2013 private equity market outlook final1

7/28/2019 2013 Private Equity Market Outlook Final1

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Table of Contents

3 A Macroeconomic Overview

11 Tactical Summary

Buyouts

12 U.S.

18 Europe

Special Situations

27 Distressed Debt

32 Mezzanine

35 Secondaries

41 Venture Capital

Select Emerging Economies

46 Asia (China + India)

57 Brazil

This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from TorreyCove Capital Partners.

Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding whether any investment is appropriate,

nor a solicitation of any type. The general information contained herein should not be acted upon without obtaining specific legal, tax and investment advice from a

licensed professional. Generally, alternative investments involve a high degree of risk, including potential loss of principal, can be highly illiquid and can charge higher

fees than other investments. Private equity investments are generally not subject to the same regulatory requirements as registered investment options. Past

performance may not be indicative of future results.



2013 Outlook

A MacroeconomicOverview

Developed markets stabilized and even

staged a muted recovery in some cases on

the back of European Central Bank actions

to contain the euro and sovereign debt

crises and continued U.S. Fed easing

policies. The prospects for a continued

improving trend in Europe and the U.S.

remain under threat from structural

imbalances, fiscal consolidation, and

deleveraging in the former, and

continuing inaction on the fiscal front

with respect to the latter. Emerging

markets, though slowed in 2012, still

undergird global growth, as they have

since the crisis erupted in 2008. In the

face of persistent policy dithering and

economic headwinds, as well as the

never-ending catalogue of geopolitical

crises, most equity markets performed

well in 2012, a trend that is likely to carry

momentum into 2013, as interest rates

reach a structural bottom and as less risk-

averse investors shift portfolios to stretch

for yield.

© 2013 TorreyCove Capital Partners



2013 Outlook


Economic Growth

U.S. real GDP increased at an annual rate of 3.1% during the third quarter of 2012 compared to

1.3% during the previous quarter and 1.3% during the third quarter of 2011, according to the

Bureau of Economic Analysis. Increases in inventory investment, government spending,

residential investment, and exports drove the quarterly growth and were partially offset by

decreased nonresidential investment. Household formation, homebuilder equities, and house

prices are on the rise and should be a driving force in 2013. Overdue infrastructure investment

and increased energy development should also increase growth and job creation. However,

short- to medium-term growth rests heavily with policymakers as markets concentrate heavily on

fiscal issues.

European GDP increased by 0.1% during the third quarter of 2012, but fell 0.4% compared to the

third quarter of 2011, according to Eurostat. Of the largest European economies, the U.K. had

the strongest GDP growth quarter-to-quarter, at 0.9%, followed by Sweden at an estimated 0.5%

growth over the third quarter of 2012. Going into 2013, effective implementation of the outright

monetary transactions program by the ECB, important elections (particularly in Germany and

Italy), France’s recent downgrade, and fiscal consolidation will present important challenges to

the restoration of business confidence and resumed economic expansion.

GDP Growth

Source: IMF © 2013 TorreyCove Capital Partners

-5%

0%

5%

10%

15%

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013E

China United States Western Europe



2013 Outlook


In Asia, Chinese GDP grew 2.2% during the third quarter of 2012 according to the Bureau of

Statistics of China. The annualized third quarter growth rate was 7.7% on a year-over-year basis.

Preliminary results for 2012 indicate a 7.8% growth rate during the year. Many believe Chinese

growth has begun to shift downward somewhat from the 10% annual rates of prior years, given

the economy’s size of approximately $8.3 trillion and somewhat less aggressive actions from the

authorities to boost growth. Outside policy shifts, China’s growth will most likely stabilize around

7.5% to 8.0% going into 2013 and beyond. The probability of growth rebounding to prior heights

is reduced in the face of decreasing private investment and manufacturing over-capacity.

During the third quarter of 2012, Japan’s GDP contracted by 0.9% compared to the second

quarter. Japanese exporters including automakers have recently benefited due to the weakened

yen as well as improving overseas economies. The Japanese government and the central bank

formed an unprecedented agreement to target 2% inflation through asset-purchases during

2013, in order to mitigate deflation.

Unemployment

U.S. unemployment decreased 70 basis points from 8.5% as of December 2011 to 7.8% as of

December 2012. Unemployed civilians decreased from 13.0 million to 12.2 million while average

weekly hours worked by all employees in the private sector slightly increased from 34.4 to 34.5

hours during the period. The number of workers unemployed for 27 weeks and over fell to 4.8

million from 5.6 million year-over-year, and the number of discouraged workers decreased 8.1%

to 909.0 thousand, but remains high relative to the pre-recession low of 274.0 thousand in

December 2006. Economic uncertainty persists, but has somewhat abated from last year, which

can be seen in the unemployment rate.




2013 Outlook



Source: Trading Economics

The Euro area reported an unemployment rate of 11.8% in November 2012, up from the prior

year’s 10.6%, representing increases of 2.0 million and 0.1 million unemployed civilians on a

year-over-year and quarter-over-quarter basis, respectively. Among the member states, the

lowest rates were in Austria (4.5%), Luxembourg (5.1%), Germany (5.4%), and the Netherlands

(5.6%). The highest unemployment rates persist in Spain (26.6%) and Greece (26.0%). Within the

EU27, eighteen states’ unemployment rates increased, seven decreased, and two were relatively

flat when compared to 2011.

Asia continued to exhibit low unemployment rates. The South Korean unemployment rate was

the lowest at 2.9% followed by India which reported 3.8%. China and Japan both experienced

4.1% unemployment rates.

Unemployment Rate U.S. Unemployment Rate

Source: Bureau of Labor Statistics

0%

5%

10%

15%

20%

25%

S p a i n

G

r e e c e

P o r t u g a l

I r e l a n d

E u r o a r e a

I t a l y

F r a n c e

S

w e d e n

U . S .

U . K .

F

i n l a n d

D e

n m a r k

B

e l g i u m

C

a n a d a

G e

r m a n y

A u s t r a l i a

N e t h e

r l a n d s

L u x e m

b o u r g

A u s t r i a

J a p a n 0%

2%

4%

6%

8%

10%

12%



2013 Outlook


Global Inflation Rates

Source: Eurostat, National Bureau of Statistics China

Inflation

Inflation in the United States slowed in 2012 as the annual change in the consumer price index

fell from 3.0% in December 2011 to 1.7% in December 2012. Food, housing, and gas prices

increased 1.8%, 1.7%, and 1.7%, respectively, during the year. However, the gasoline index

declined in each of the last three months of 2012. The energy index increased 0.5% during 2012,

which represents a strong deceleration from 2011, when energy prices increased 6.6%. Within

the food index, five of the six groups increased during December. For the year, the items that

declined were used vehicles (2.0%) and household energy (1.1%). Four of the twelve months in

2012 experienced deflation and after a 0.5% decrease in November, December was flat.

The EU annual inflation rate was 2.3% in December 2012, down from the prior year’s 3.0%. The

highest annual rates were recorded in alcohol & tobacco (3.6%), housing (3.4%), food and

education (both 3.0%), while the lowest inflation rates were for communications (-3.8%),

household equipment (1.0%), and recreation & culture (1.2%). Geographically, the lowest

inflation rates were observed in Greece (0.3%), Sweden (1.1%), and France (1.5%), and the

highest in Hungary (5.1%), Romania (4.6%), and Estonia (3.6%).


-4%

-2%

0%

2%

4%

6%

8%

10%

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

European Union US China



2013 Outlook


China’s annualized inflation rate was 2.5% in December 2012, near the 10-year average of 2.6%

and markedly down from last year’s 4.1%. Food prices increased 4.2%. Of the various food

groups, fresh vegetables increased 14.8% and fresh fruit decreased 5.6%. Gasoline prices

increased 2.6% and residential prices increased 3.0%.

Sovereign Banks

The Federal Reserve’s balance sheet broke through $3 trillion for the first time in history in

January 2013, and has more than tripled since 2008 in its effort to keep rates low and stimulate a

weak economy. In December, the Federal Reserve committed to $40 billion and $45 billion of

monthly purchases of MBS and long-term Treasuries until unemployment rates drop. However,

some officials indicate the purchase program may discontinue by year-end 2013.

In September, the European Central Bank established an open-ended bond purchase program to

alleviate borrowing costs in troubled nations including Spain. Due to market sentiment, the

program’s establishment reduced Spanish and Italian bond yields without actually purchasing


Central Bank Rates

0%

2%

4%

6%

8%

10%

12%

J a p a n

U . S .

U . K .

E u r

o a r e a

F r a n c e

G e

r m a n y

I t a l y

C

a n a d a

S o u t h

K o r e a

A u

s t r a l i a

T u r k e y

I n d o n e s i a

C h i n a

B r a z i l

I n d i a

R u s s i a

2010 2011 2012

Source: Trading Economics



2013 Outlook

0

100

200

300

400

500S&P 500 Russell 3000

MSCI Emerging Mkt FTSE 100

DAX 30


bonds thus far. Interest rate spreads are down across the region, pointing to subsiding fear and

returning confidence as most investors agree the worst has passed. The European Central Bank’s

balance sheet decreased €150 billion from its peak in June and currently stands at €2.94 trillion.

The People’s Bank of China (“PBOC”) recently enacted new short-term liquidity measures,

supplementing its current market operations. The change marks a slight migration toward the

typical tools used by other major central banks. Last year, the PBOC cut reserve ratios in February

and May, and lowered benchmark interest rates in June and July. This year the PBOC will most

likely rely more on open market operations. Historically volatile money market rates should

stabilize as the PBOC becomes more flexible.

Public Markets

Despite slowed economic growth in both developed and emerging markets, the equity markets

did well in 2012. The S&P 500 and Russell 3000®1 returned 16% and 16.4%, respectively, marking

a solid year that was still outpaced by the German DAX Index which rose 29.1% for the year.

Compared to last year, volatility measured by the VIX Index decreased.

Public Markets Returns

Source: Bloomberg


0

50

100

150

200

250

300

2011 2012

VIX Index

Source: Bloomberg

1 Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to theRussell Indexes. Russell® is a trademark of Russell Investment Group.

®



2013 Outlook


The Outlook for 2013

World output is projected to increase to 3.5% in 2013 from 3.2% in 2012, according to the IMF.

Advanced economies are expected to grow 1.4%, including U.S. growth of 2.0%. U.S. Inflation

trended down and is expected to decrease further before reverting closer to its 10 year mean

just above 2%. U.S. household formation, homebuilder equities, and house prices are on the rise

and should be a driving force in 2013. Depending on successful policy change, overdue

infrastructure investment and increased energy independence would also increase growth and

job creation. However, peripheral issues may attract less attention as Washington focuses on

fiscal consolidation. Bottomed interest rates have heated the high yield market, leading to

increased risk appetite as investors desperately hunt for yield. Likewise, with debt costs, falling

buyout firms have been using more leverage on deals and average debt multiples have

approached pre-crisis levels. Similarly in Europe, political stalemate and fiscal drag will continueto influence volatility.

Europe’s economy is expected to modestly recover to 0.4% growth in 2013 from -0.3% in 2012.

The EU held together during 2012 and most believe the worst of its recessionary pains have

passed. The key risk will be effective implementation of the recently established Outright

Monetary Transaction (“OMT”) process, which will add financial stability, leading to economic

stability. Elections in Italy and Germany will also impact the region’s recovery. Election results in

Italy may unravel the reform achieved by the current Monti government. In Germany, the

elections may slow decision-making in Europe, increasing uncertainty. Tangentially, global

growth may support Europe’s weaker nations as they continue to adjust to austerity.

Japan’s focus on a targeted inflation rate through open-market purchases to combat deflation

should boost growth. However, stimulus could be transitory absent medium-term fiscal reform.

Emerging markets are expected to grow 5.5% in 2013, from 5.1% in 2012. Change in policy has

strengthened growth, but weaknesses in the developed markets will negatively affect demand.

Chinese GDP is expected to modestly increase to 8.0% in 2013. China’s growth depends on

shifting the economy toward private consumption.




Select Emerging Economies > page 46

ASIA > CHINA > page 51

Resuming growth trend, reduced inflation fears, medium-term growth trend remains in place, more favorable

valuations

M O D E R A T E

O V E R W E I G H T

ASIA > INDIA > page 54

India: Reduced growth, inflation still relatively high, reform efforts stalled, and some export weakness

N E U T R A L

BRAZIL > page 57

Sub-optimal macroeconomic growth picture, inflation fears reduced but not gone, export weakness. Positive factors:

demographic medium and longer-term growth, decreased valuation of Brazilian currency

N E U T R A L

Tactical Summary

Buyouts > page 12

12- to 18-month

commitment

outlook >

SMALL ($500 Million and Below) and MIDDLE MARKET ($500 Million to $5 Billion)

Relatively stable investment and exit activity slightly lower leverage at small end

M O D E R A T E

O V E R W E I G H T

LARGE ($5 Billion and Over)

Rebounding deal flow and investment activity, especially in North America; improved exit markets

N E U T R A L

European Large Buyouts > page 18

Much-improved situation regarding sovereign debt and Euro crises; expectation of some dynamism returning to buyout

space

M O D E R A T E

U N D E R W E I G H T

Special Situations Distressed Debt, Mezzanine, + Secondaries > page 26

DISTRESSED DEBT > page 27

Strong dynamics within debt markets, low default rates, continued Fed accommodation, and improving U.S. economy

N E U T R A L

MEZZANINE > page 32 Improving buyout deal flow and reduced equity contributions; competitive environment for debt creates pricing

pressure

M O D E R A T E

U N D E R W E I G H T

SECONDARIES > page 35

Reduced selling pressure globally, but still expecting strong year for deal flow; tightness in pricing expected to persist

N E U T R A L

Venture Capital > page 41

Exit markets open after strong 2012; continued balance in supply/demand of capital; visibility needed on next major

trend(s)

N E U T R A L

It should be noted that TorreyCove’s private equity portfolio management methodology emphasizes the equal or greater importan ce of manager selection in relation to othe

elements of the portfolio management process, such as regional or sector weightings. For this reason, a client may pursue an investment with a top-performing investment

manager even when a region, sector, or strategy is deemed less attractive on a relative basis. These are guidelines; an institut ion’s weightings may differ based on their curr

portfolio composition and overall goals, objectives, and risk tolerance. © 2013 TorreyCove Capital Partners

Ratings are tacticalrecommendations and

assume a portfolio with astable strategic allocation



In 2012, buyout strategies appeared to have finally broken out of the relative torpor that had

engulfed them for much of the post-crisis period and most measures of activity were in a strong

uptrend for the year. Overall, U.S. buyout and mezzanine fundraising came in at approximately

$154 billion for 2012, putting the year just short of the healthy level seen in 2005. While this is

about 50% off of the 2007 peak, it is much more in line with the sustainable trend over the past

decade and should balance well with expected market supply/demand over the next few years.

Fundraising

This past year also marked the return of the mega buyout fund. In fact, mega and large buyout

funds accounted for a material portion of the increase in committed capital during the period,

shifting the balance of fundraising back to the larger side of the market where it traditionally

resides. While middle-market funds ($1B to $5B) were still the largest gatherers of commitments

for the year, with about 43% of the total, they were far less a factor than in 2011, when they

accounted for over two-thirds of the total. Meanwhile, commitments to mega funds (over $5B)

more than tripled from 2011, when they were a meager $14B. The smaller end of the market

remained steady, with sub-$1 billion funds taking in a healthy $30 billion in 2012. In terms of

strategy, energy and power was once again highly favored.

Investment Activity

Capital deployment by buyout shops remained steady in 2012, proving that the recovery of the

sector that began in 2010 has legs. In comparison to its predecessor, 2012 was a bit of a

disappointment, with a poor first quarter ($12 billion deployed) costing it a chance to equal the

Buyouts > U.S.

Source: S&P © 2013 TorreyCove Capital PartnersSource: S&P

Average Debt Multiples of Large Corporate LBO Loans Purchase Price Multiples

0x

5x

10x

2 0 0 0

2 0 0 1

2 0 0 2

2 0 0 3

2 0 0 4

2 0 0 5

2 0 0 6

2 0 0 7

2 0 0 8

2 0 0 9

2 0 1 0

2 0 1 1

2 0 1 2

4 Q 1 2

Senior Debt/EBITDA Sub Debt/EBITDA

Equity/EBITDA Others

01234567

2 0 0

0

2 0 0

1

2 0 0

2

2 0 0

3

2 0 0

4

2 0 0

5

2 0 0

6

2 0 0

7

2 0 0

8

2 0 0

9

2 0 1

0

2 0 1

1

2 0 1

2

4 Q 1

2

Sub Debt/EBITDA Other Sr Debt/EBITDA

SLD/EBITDA FLD/EBITDA


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Buyouts > U.S.

prior year’s activity, instead coming in close to 25% lower. However, quarterly investment totals

were running within striking distance of 2011’s quarterly totals, indicating that there is not a

significant downtrend in terms of capital deployment.

In terms of investment activity, the U.S. buyout space remains a “seller’s market.” Purchase pricemultiples for deals showed no sign of moderating in 2012, and in fact ticked up slightly from last

year’s level, to just over 9x EBITDA (all buyouts), the highest level other than at the peak of the

boom, when multiples exceeded 10x EBITDA. The stickiness of purchase multiples holds through

nearly all deal sizes (especially those over $250 million), with only the smaller end of the market

showing signs of a moderation in the steady rise that has been in play since the end of the post-

crisis recession.

Purchase multiples are being supported by a variety of factors, with two of the most impactful

being Fed monetary action, which has served to inflate asset values, and the higher level of risk

tolerance exhibited by investors in today’s market, compared to even two years ago. The

abundant availability of very low cost debt and remainder of the capital overhang that must be

burned-off by buyout shops round out the most important factors putting a relatively high floor

under buyout deal pricing. We do not anticipate a major change in this dynamic over the next 18

months.

Exits

Buyout funds put in a fairly decent year with respect to exits, at least when one looks at the

number of deals. For 2012, over 440 buyout-backed companies were exited through the M&A

channel, with a total value for disclosed deals (165) of $70 billion, identical to the amount for

Source: &P Capital IQ M&A Stats December 2012 Source: Thomson Reuters, Buyouts

0

50

100

150

200

Mega Funds($%B or more)

Large-MediumFunds

($1B to $4.99B)

Mid-Market funds($300M to $999M)

Small funds(up to $299M)

2007 2008 2009

2010 2011 2012

LBO Funds Raised By Target Size Through 2012 ($B)

0

100

200

300

400

500

600

700

2005 2006 2007 2008 2009 2010 2011 2012

4Q 3Q 2Q 1Q

167.46

313.38

603.17

158.05

34.7691.00 125.19 167.46

U.S. –Based Disclosed Deal Value By Quarter



Buyouts > U.S.

2011, when the deal count was nearly the same (455). The IPO route opened up somewhat, as

40 buyout-backed deals found their way onto public exchanges in 2012, nearly double the

number from 2011. Overall, the exit environment for buyout companies last year is best

characterized as open, active, and stable, but not robust. Most importantly, each of the past two

years has seen significant improvement from the relative freeze of 2009, and we expect a more

supportive environment for exits will develop over the next 12 to 18 months.

Outlook

Last year at this time, we anticipated a relatively steady year for the buyout asset class in terms

of fundraising, investment, and exits. As it turned out, the fundraising numbers were much

stronger than what we had expected, primarily due to the entry into the market of several large

buyout funds, as well as a renewed willingness on the part of investors to take risk. On the

investment front, we were generally correct that 2012 would remain in a stable state compared

to 2011. We expected the M&A exit route to hold steady, and it did, while the IPO exit route

showed some signs of additional life. We expect a decent fundraising year for buyouts in 2013,

at or near the levels seen in 2012, which we now think of as closer to the “normal” state for the

asset class, due to the increasing private equity allocations of large institutional investors over

the past few years, a trend that is likely to continue as return expectations for other asset classes

remain flat or in decline. One factor that may lead to a somewhat lower fundraising take in 2013

when compared to last year is that most of the mega buyout funds have closed, or are about to

close, leaving the middle market to take up the slack. Investment activity should pick up

appreciably as the market puts fear and risk aversion further in the rear view mirror, leading to

STRONG

OVERWEIGHT

MODERATE

OVERWEIGHT

NEUTRAL

MODERATE

UNDERWEIGHT

STRONG

UNDERWEIGHT

to 18-monthcommitment

outlook >

STRONG

OVERWEIGHT

MODERATE

OVERWEIGHT

NEUTRAL

MODERATE

UNDERWEIGHT

STRONG

UNDERWEIGHT


outlook >

youts > U.S. Small and Middle Market

youts > U.S. Large




Buyouts > U.S.

increased animal spirits on the part of investors and buyout funds alike. Fueling the entire sector

will be the continued provision of easy, cheap debt financing, courtesy of the Fed. The stage is

also set for an uptrend in the exit environment for buyouts, which already appears to have

generated some momentum in 2012. Now that markets are feeling increasingly confident thatthe risk of a major collapse is further in the distance, corporate cash stockpiles are increasingly

likely to find their way into M&A transactions. This will be aided by continued strong pricing

dynamics and the more aggressive stance of the buyout sector, as well as the ever-present low

cost financing.

Some key factors relating to the North American buyout sector over the next 12 to 18 months are

as follows:

• Purchase multiples will remain near the levels seen in 2012, underpinned by increasing

competition amongst buyout investors, increasing interest from strategics, and abundant

financing availability. A modest reduction in the capital overhang (if it occurs) and stronger

deal flow (also a possibility) are not likely to put much downward pressure on purchase

multiples in the light of the strong macro factors setting a floor under price. If any change is

to occur, it is more likely to be to the upside.

• Secondary buyouts, already having gained considerable steam in the past year, especially in

the U.S., should prove resilient for a time in 2013, as large and middle market firms seek to

deploy the last of their commitments from prior funds before they expire. To illustrate, North

American buyout shops completed $34 billion worth of secondary deals in the first three

quarters of 2012, accounting for 61% of global secondary value and representing a post-crisishigh for this exit route (Source: Preqin Private Equity Spotlight October 2012). Until deal flow

picks up further, secondary buyouts will continue to present a viable option for buyout shops

to get deals done.




Buyouts > U.S.

• Leverage levels associated with buyouts have returned to within striking distance of the

levels last seen in the bubble era, at least for the larger transactions. Overall multiples as of

the fourth quarter of 2012 stood at 5.5x EBITDA, the highest reading for all but two of the

past 15 years, one of which was 2007 (6.2x). Interestingly, first lien debt, which was recentlyhovering just below 4x EBITDA – where it peaked at the height of the bubble – never

collapsed the way it did in the prior recession. After falling somewhat close to 3x in the

aftermath of the financial crisis, first lien debt steadily ratcheted upward to its current level.

By contrast, in the prior recession, first lien debt fell to near 2x before beginning its rise.

Middle market lenders are only moderately more cautious than their large market

colleagues, providing about 5x EBITDA in total debt most recently. However, first lien debt is

actually slightly higher within the middle market, at approximately 4x EBITDA. We assume

very little downward pressure on debt multiples for 2013, given the highly accommodative

monetary policy maintained by the world’s central banks.

• In a related vein, the return of pre-crisis leverage levels has recently been accompanied by

some other notable practices from that era, including “covenant-lite” loans and dividend

recaps. So long as leverage is freely available, these trends are not anticipated to abate

significantly.


Breakdown of Aggregate Secondary Buyout Deal Value by Region 2006-Q3 2012

0%

20%

40%

60%

80%

100%

2006 2007 2008 2009 2010 2011 Jan-Sep

2012

Asia and Rest of World

North America

Europe

Source: Preqin Buyout Deals Analyst



Buyouts > U.S.

• The past two years have seen a return to a more “normal” pattern for distributions to limited

partners (for funds of the 2004 through 2008 vintages), due in part to the large number of

large and middle market funds on the fundraising trail, as well as improving market

conditions. We expect 2013 to continue this trend, barring a major disruption that sapseconomic confidence.

• The preference of large institutional limited partners to cull the ranks of their private equity

portfolios has not abated, and we continue to expect a further rationalization of the manager

universe, with marginal performers and many less-established funds dropping by the

wayside.

• The industrial sector in North America is expected to become more attractive to buyout

shops in 2013, perhaps displacing the energy sector as the darling of the buyout asset class.

•With sub-par but stable growth in North America and the Euro crisis at bay until furthernotice, buyout activity should pick up in 2013 and managers are expected to shift somewhat

into a more risk tolerant posture. Therefore, growth is expected to become a more

prevalent theme (as opposed to downside protection) on a relative basis.

• The valuation trend for buyout fund portfolio companies should bias upward, as the M&A

markets remain steady, macroeconomic performance improves, and the IPO markets show

some life (though nothing like the past glory days).

Our tactical rating for the large buyout sector is moving from “Moderate Underweight” to

“Neutral” based on improving deal flow, exit opportunities, and macroeconomic conditions in the

important North American region. Our tactical rating for the small and middle market buyout

sectors remains “Moderate Overweight.” An upward trend for both segments is expected for

2013 with respect to investment, valuation, and exits.




European buyouts had a generally unremarkable year, with fundraising and investment flows

remaining at generally quiescent levels for much of 2012 in comparison to the last year, as the

market appeared to test the newfound stability in the euro currency dynamic. A relatively strong

fourth quarter for investment could indicate a return of some semblance of optimism, a renewedenthusiasm by value investors, or simply a false dawn. The first half of 2013 should give a better

sense of which.

Fundraising

2012 posted a modest increase in fundraising by buyout funds year-over-year, driven

substantially by the closing of a few established large funds such as Advent GPE VII ( €11 billion)

and BC European IX (€7 billion). In total, European buyout strategies raised €76 billion, a

meaningful increase of 13% over 2011 levels. However, for perspective, this amount was still less

than half of the peak fundraising years just prior to the financial crisis and still significantly below

2005 numbers, which are presumably representative of a more sustainable fundraising

environment. Nevertheless, 2012 fundraising was very much in line with the levels seen in the

post-crisis period and the third improvement in as many years, indicating that demand for buyout

investing in the region has at least established stability and is clawing back year-by-year.

Buyouts > Europe




Buyouts > Europe

Investment Activity

In total, 2012 will go down as a rather disappointing year for buyout deal making, but one that

was punctuated by a fourth quarter that showed some real signs of life. After a decent first

quarter showing in terms of buyout deal volume, where the number of deals broke 100 and

rebounded from a poor figure in the fourth quarter of 2011, buyout volume settled into a mid-

year slump where volume traded in the 90s. Meanwhile, value ranged from approximately €12

billion to €15 billion over the first three quarters, as the hangover from the most recent eruption

of the Euro crisis in late-2011 hung on. However, the fourth quarter of 2012 more or less saved

the year, as deal value – propelled by a flurry of late-year mega deals – bumped up to over €22

billion (82% quarter over quarter), in spite of a stagnant deal count. It is too early to make a guess

as to whether this is the beginning of a more sustained recovery in investment activity, or simply

a blip within a more stagnant trend. In fact, the full-year totals for buyout investment activity still

came in below the past two years, on both deal count and value. Given that 2010 – 2011 were

not blockbuster years themselves, the environment for deploying buyout capital in the EU still

presents significant headwinds. What can be said is that, with the latest installment of the

currency crisis increasingly in the past, the investing appetites of buyout shops operating in

Europe appears to have increased on the margin. In terms of deal size range, the large/mega

segment came back to life to an extent in 2012, accounting for over one-third of total value for

the year, while the middle market and small market segments slipped somewhat. By region, the

UK and Nordic regions came away winners, both generating substantial increases in deal value

during the fourth quarter, in comparison to the third quarter of 2012. In particular, the UK saw itsdeal value nearly triple from the third quarter, driven once again by a few large cap transactions.




Buyouts > Europe

Exits

European exit markets were less than accommodative in 2012, with the IPO route still effectively

closed to most private equity companies. In 2012 there was a handful of IPOs of PE-backed

companies generating just over €1 billion in proceeds, approximately one-third of what was

generated in 2011, itself a less than stellar year. The outlook for a major opening of the public

markets for European deals remains muted for 2013.

The trade sale/M&A route also declined, in both number and amount, from 2011 levels. While

the number of deals exited via trade sale was only slightly off from 2011, the total value of such

deals declined by approximately €13 billion, or over 50%. Secondary sales, always a relatively

popular way to exit in the European buyout space, held up much better, with 2012 only about €1

billion off from 2011s €18 billion.

Given a marginally improved and more stable current macroeconomic situation in Europe, the

prospects for substantial increases in both trade sales and secondary sales are much brighter

than for IPOs, as cash-rich strategic players and more aggressive private equity shops look to

capitalize on value opportunities in the EU.


Volume and Value of European Private Equity-backed Buyouts

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Q4 2010 Q1 2011 Q2 2011 Q3 2011 Q4 2011 Q1 2012 Q2 2012 Q3 2012 Q4 2012

Source: Q4 2012 unquote” Private Equity Barometer

Value ( €bn)Volume



Buyouts > Europe

Outlook

In 2012, the focus in Europe shifted from fear to one of relatively stable gloom. The periodic

euro currency and sovereign debt crises that roiled the continent since 2010 were tamed, at least

for a time, by the actions of the European Central Bank. Whether intentional or not, the ECB’s

extension of low-cost liquidity to the banking sector via its three-year term loan program,

coupled with Mario Draghi’s statements that effectively “talked down” the emerging runs on

peripheral sovereign debt, had the effect of quelling bond market anxiety and putting the

European banking system on somewhat better footing early in 2012. With the immediacy of the

euro and sovereign crises in abeyance, the markets are now paying attention to the medium- and

longer-term prospects for the EU economies. On that front, the picture is still not terribly pretty.

Overall, the EU has shown little traction in terms of GDP growth, with even some of the more

resilient economies faltering. While not necessarily a solid consensus view yet, a substantialbody of market opinion is predicting a “lost decade” scenario for the Eurozone countries, due to

the major structural problems which continue to bedevil the region despite the temporary

removal of the more immediate Euro crisis. Some of the trends and issues that should figure

meaningfully in EU markets over the next couple of years are described below:

• As noted earlier, real GDP growth for the core European countries remains poor. After a

recessionary year in 2012, projections for real GDP growth for the Euro area (17) are more or

less flat for 2013 (0.1%) and 1.4% for 2014. Even the better performers like Germany saw a

difficult year in terms of growth, as their trading partners within the EU experienced

recession/slow growth and austerity. After a reasonably good year in 2011 (3.0% growth),

Germany slipped under 1% for 2012 and is not expected to break that threshold in 2013,

though 2014 may see reasonable growth resume. The region’s second and third largest

economies, France and Italy, have fared even worse and are both expected to underperform

the average in 2013 and 2014.

STRONG

OVERWEIGHT

MODERATE

OVERWEIGHT

NEUTRAL

MODERATE

UNDERWEIGHT

STRONG

UNDERWEIGHT


outlook >




• While it would be unwise to say that the European banking system as a whole is well-

capitalized, there was definite improvement within the sector in 2012. Around this time last

year, the system’s largest institutions were under orders from the European Banking

Authority to boost capital by well over €100 billion and many were practically shut out of theinterbank lending markets. Since then, these major banks have increased capital cushions by

a reported €116 billion or more and the larger EU banking system by over €200 billion. Also,

in a report released in January 2013 by the EBA, median Tier I capital ratios were reported as

having increased from approximately 11% to nearly 12% over the course of 2012, primarily

as a result of the retention of earnings and secondarily as a result of capital raises. We would

add that the “Draghi carry trade” appears to have been a major contributor to these

improved capital ratios. Deleveraging was not a material factor.

3.2 3

0.4 -4.4

21.4

-0.4 0.11.4

-5

0

5

2006 2007 2008 2009 2010 2011 2012 2013 2014

Buyouts > Europe


European Area GDP Growth Expectations

Source: Eurostat



Buyouts > Europe

• Of course there are informed market participants that are more than a little skeptical

regarding these capital ratios, citing the gingerly treatment given to dodgy sovereign debt

assets (Spain and Greece) in the calculation as well as other “loopholes” afforded to banks in

Europe that are not extended to other international institutions (Source: BIS). In a specificcase, the Bank of International Settlements took issue with a recent report by consultant

Oliver Wyman on the new capital requirements for the Spanish banking system, indicating

that the €76 billion euro total was probably only half of the ultimate requirement.

• Probably the best way to characterize the European banking situation at the beginning of

2013 is stable and modestly improved in terms of capital adequacy. The actions of the ECB

have effectively bought major banks some time and flexibility with which to clean up their

balance sheets, but the pressure to do so is not likely to go away.

• The state of affairs in the European financial system point to a continued credit shortfall on

the continent, as banks continue to limit risk by curtailing lending in certain areas and

deleveraging. While large enterprises will continue to obtain financing at reasonable terms

and sovereign debt issuers will find a friendly banking system willing to purchase their debt,

middle and small market enterprises will continue to find the lending window either shut or

significantly diminished. Taken in aggregate, this should prove a headwind to economic

growth across the region.


04080120160200240280320

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1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

1Q 2Q 3Q 4Q

Annual Senior Loan Volume

DEALCOUNT

Source: S&P M&A Stats

€ Billion



Buyouts > Europe

• As expected, the problems of the EU periphery found their way into the core during 2012, as

heavily-constrained economies like Italy, Spain, Greece, and others provided less demand for

goods from Germany and other stronger countries. As the bulk of Germany’s trade is

inter-EU, this knocked its GDP down severely, sending it down to a near-recession level forthe year. This situation is expected to improve modestly by 2014, but 2013 is set to be

another relatively flat year for growth.

• There was little change in terms of leadership in the private equity investment arena from

2011 to 2012, with the UK and the Nordic regions showing the most heat, due to their

relative insulation from the currency and sovereign debt crises. A continuation of this trend

for at least the duration of 2013 appears the most reasonable assumption.

• With some exceptions, the prognosis for the private equity asset class (emphasis on buyouts)

in Europe will be similar to that of the beginning of 2012. The primary difference will be the

absence of the scythe of a currency crisis hanging over the region, at least for the time being.

The key trends should be as follows:

• The availability of leverage is likely to open a bit, as financial institutions build capital, but

this is not expected to be a major improvement, as deleveraging still beckons and risk

aversion remains high. Further, this phenomenon is expected to be limited to the larger

end of the commercial scale.

• Deal flow is likely to increase on the margin, as investors infer lower risk in the EU

compared to a year ago. Value plays should outnumber growth plays, while rescue

situations may be more common. Overall, the environment should be opportunistic and

value-oriented and the momentum for larger deals that began in 2012 should carry into

2013.

• There is no recovery for IPO markets in sight in 2013, but M&A should remain steady.

Secondary buyouts will continue to be an important exit route for Europe-based deals and

is likely to accelerate as investment activity by buyout firms increases.




Buyouts > Europe

• The investment levels seen in the fourth quarter of 2012 are likely the beginning of an

uptrend rather than a blip in a downtrend, so private equity investment in the EU should

show a meaningful rebound in 2013.

• In terms of the most advantageous private equity investment strategies, much of the gameplan from last year remains, but against a perceived lower-risk backdrop with more visibility

on growth (or lack thereof). Focusing on taking advantage of the credit hole, purchasing

attractive assets from deleveraging financial institutions, and expanding investment in

Europe-related high-growth economies like Turkey, still look to be sound strategies.

Our tactical rating for European large cap buyouts is moving from 2012’s “Strong Underweight”

to “Moderate Underweight” for 2013. While the debt and currency crises have most likely just

been deferred and not solved, there is substantially more stability in the region than at this time

last year. The banking system, while not even near top form, has made some progress inaddressing its capital problems. Unfortunately for the EU, much of the cure for what ails it (or at

least the medicine that is being prescribed) is likely to cause substandard economic growth for

years to come. These factors include fiscal austerity, slow-moving structural reforms, a

continued curtailment of credit for certain important sectors of the economy, and persistent

uncertainty as to the longer-term prospects and pathway to further integration of the EU and

Euro zone. There is no reason to assume anything near traditional European growth levels of

prior years coming to pass in the near term and the case is not too good for the medium term. In

spite of this, the situation is more stable at present and immediate major risks of a collapse have

been disposed, which bodes well for value-oriented private equity investors.




Special Situations

Overview

The prospects for special situation strategies shifted appreciably in 2012. Secondary strategies

put together yet another exemplary year, with both fundraising and investment of capital

extending the momentum from recent prior years, especially on the investment side. With a

slowdown in deal flow nowhere to be seen and an aggressive posture by secondary managers,

2013 promises to be yet another good year. However, pricing has remained stubbornly high, the

market for large transactions has been relatively efficient, and the supply of capital to secondary

strategies has increased substantially, all of which indicate that the prospect of making excess

returns in the space has probably become marginally less viable. Distressed strategies have been

waiting for a massive debt market dislocation ever since the crisis hit – a dislocation that never

really materialized. The U.S. Fed’s easy money policy and quantitative easing have effectively re-

inflated the debt markets and saved the day for all but the worst enterprises. After a brief spike,default rates have remained at very low levels in recent years, making life quite difficult for

distressed investors trying to turn a profit. After some years of difficulty due to reduced deal

flow from the buyout sector and “over-equitization” transactions by buyout investors, the

mezzanine strategy looks to be on a better footing at the beginning of 2013. With buyout deals

coming back briskly and leverage levels reaching heights last seen before the crisis, along with

falling equity contributions, mezzanine appears to have found its place in the world again. The

next year or two should turn out to be substantially more robust for mezzanine strategies than

those directly after the crisis.




Investors’ Geographic Preferences for

Distressed Private Equity Funds, October 2012

Special Situations > Distressed Debt

Fundraising

After a blowout 2008, when approximately $57 billion was raised for distress-related funds, the

strategy saw a steep drop-off in fundraising in 2009. However, once investors regained some

confidence in private equity, the strategy settled into a steady, but relatively strong, fundraising

trend over the next two years, when it raised between $25 billion and $30 billion in each year.

Benefiting from this momentum, 2012 is currently on track to post a fundraising total for

distressed strategies that will rival 2010 and exceed 2011. As expected, investor sentiment for

the distressed space has shifted on a relative basis to a more Euro-focused stance (see nearby

graph), and European-oriented managers posted a strong 2011 fundraising total of nearly $8

billion, or nearly one-third of the total (due almost entirely to the closing of one large, established

fund during the year). In terms of fundraising, the story is one of high investor demand and a

relatively constrained supply. Therefore, we do not anticipate a major shift from North Americandominance of distressed fundraising, but Europe should play a strong secondary role for the next

few years. Given investors’ stated positive attitude toward distressed investments and the

number of funds in market, we expect 2013 to prove another solid year on the fundraising front.

Source: Preqin

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2005 2006 2007 2008 2009 2010 2011 Jan-Aug2012

No. of Funds Raised

Aggregate Capital

Commitments ($bn)


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NothAmerica

Europe Asia Rest of World

Source: Preqin

Annual Distressed Private Equity Fundraising,2005-August 2012



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2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

(3Q)


Investment Activity

Compared to one year ago, the prospects for attractive deal flow and aggressive deployment of

capital have dimmed for distressed firms. With respect to the drivers of this state of affairs,

there is not too much new to report. As noted over the past couple of years, the Fed is probablythe biggest culprit making life difficult for distressed investors. With its statement indicating zero

or near-zero interest rates through at least 2014 (or until the unemployment rate drops to below

6.5%) and continued liquidity provision at the longer end of the bond markets, the Fed has

created a monetary environment in which only the worst companies can fail. As evidence,

consider the quarterly U.S. high yield default rate, which has been above 0.50% only once in the

last 11 quarters (Altman) and came in most recently at 0.24 %. There have been only a handful of

meaningful defaults in 2012, including: Residential Capital ($3.1 billion); ATP Oil & Gas Corp.

($1.5 billion); Eastman Kodak ($1 billion); and Sino-Forest ($1 billion). Other factors that are

contributing to the effective ceiling on the default rate include: large and growing cash balanceson corporate balance sheets, the improving U.S. economy, strong high yield and leveraged loan

markets, and the relative ease with which decent companies can obtain refinancing. Of course,

the prospect of a slowdown in the developed world is ever-present, what with the recurrent

fiscal showdowns and shifting tax structures in the U.S., and the never-ending saga of the euro.

Either of these dynamics, or some that are not foreseen, could trigger a wealth of deal flow for

distressed investors. But compared to one year ago, the investment prospects for distressed

fund managers would have to be seen as more limited.

High Yield Default Rate Straight Bonds Only

Source: Altman & Kuehne High-Yield Bond Default and Return Report © 2013 TorreyCove Capital Partners




Distressed Debt Outlook

After appearing to be poised for a breakout a little over one year ago, distressed strategies

witnessed the trend moving away from them in some significant respects. Due to its nature as an

opportunistic investment class that thrives on market dislocation, forward-looking projections for

distressed strategies are always somewhat difficult. At the present time, the situation is

particularly fluid with respect to these strategies, as different factors are moving in different

directions. Some of the more important factors – most of which are negative (bullish for

distressed strategies) – are noted as follows:

• In late-2011, the U.S. defaulted and distressed debt market was estimated at $1.6 trillion, its

highest level since 2008. Most recently, the market is estimated at $1.3 trillion. While some

of this is due to reclassification, much of it results from the general decline in distress levels

in the debt markets. (Source: Altman and Kuehne High-Yield Bond Default and Return ReportNovember 2012).

Percentage of New High-Yield Issuance Rated B- or Below Based on the Amount of Issuance

STRONG

OVERWEIGHT

MODERATE

OVERWEIGHT

NEUTRAL

MODERATE

UNDERWEIGHT

STRONG

UNDERWEIGHT


outlook >

Source: S&P’s Global Fixed Income Research

0%

10%

20%

30%

40%

50%

60%

1 9 9 3

1 9 9 4

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3 Q 2 0 1 2





• Another useful measure of distress, the ratio of high yield bonds trading at or above 1,000

bps over comparable U.S. Treasuries, also showed significant easing during 2012. After

straying into the red zone in the third quarter of 2011 (22% versus an average of 15%), this

measure moderated considerably in the subsequent year, ending the third quarter at 11.0%.(Source: Altman and Kuehne High-Yield Bond Default and Return Report November 2012)

• Through the third quarter of 2012, the trailing 12-month default rates for both high yield

bonds and leveraged loans maintained very low levels, close to 1% each. In the context of

the current economic environment, such low default levels are highly unusual.

One of the better demonstrations of the new willingness of investors to take on risk is provided

by the strength of the public debt markets. Driven by intense investor demand for yield (and a

willingness to stretch to get it) debt markets have obliged with record, or near-record issuance in

the past several months, all of this coming on top of what was a solid year for public debt in2011. On the supply side, companies have used the opportunity afforded by the Fed to refinance

at extremely low rates and push out upcoming maturities further. U.S. high yield issuance

through the third quarter of 2012 was about $239 billion ($186 billion for first nine months of

2011) and leveraged loan issuance of $116 billion was more than double the comparable period

in 2011.

High Yield

Source: Fitch Ratings © 2013 TorreyCove Capital Partners

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High Yield

Issuance ($B)

Default

Rate




The quality of high yield issuance appears to have remained relatively consistent and in line with

historical averages over the past few years since the crisis (in 2007, about 50% of issuance was B-

or lower), with about 23% of issuance rated below investment grade through the third quarter of

2012 (average of past five years of 29%).

In most respects, the environment for distressed strategies has not changed appreciably from the

beginning of 2012. The Fed maintains a very accommodative monetary policy, U.S. economic

performance is slowly improving, stasis prevails on the U.S. fiscal front (punctuated by highly-

publicized political battles that ultimately end up with less than durable fixes and erode market

confidence), and the Euro crisis periodically breaks through to dominate economic events, only to

be quieted with another temporary fix. In the meantime, fundraising for distressed strategies

continues at a rather robust pace. One thing that has changed is the acceleration of the issuance

of high yield securities, which has been accompanied (and probably caused) by an increasing

investor willingness to snap up these issues. And so the outlook for distressed strategies is much

the same as last year: in general, a quiet environment waiting for a crisis to ignite a strong run for

distressed investing. The likely actors in this drama – a budget crisis in the U.S. or a major shock

from the EU – have not changed. However, the increasing volume of high yield securities issued

over the past two years is likely to serve as kindling for the distressed opportunity, if and when it

emerges. The primary headwinds to the strategy are Fed policy and steady (though substandard)

growth in the U.S.

Our tactical rating for distressed strategies is being moved from “Moderate Overweight“ to

“Neutral” given the increased availability of high yield debt, improving U.S. economy, and

continued “all in” posture of the Fed in providing liquidity and maintaining a historically low cost

of capital. These elements, while keeping distress at bay for the foreseeable future, are likely to

increase the magnitude of distress once a triggering event occurs. Therefore, we expect an

excellent opportunity for the strategy within the next three to four years, but believe the

likelihood of such an opportunity over the next 12 to 18 months has lessened.




Special Situations > Mezzanine

Fundraising and Investment

Mezzanine strategies appear to have found a steady state in terms of fundraising in the more

recent post-crisis years. After a difficult year in 2009 (along with most other private equity

strategies), mezzanine funds have garnered at or near $10 billion in commitments for each of the

past three years ending in 2012. These amounts are quite consistent with the pre-crisis years

leading up to, and through, 2005 (the bubble years of 2006 through 2008 saw commitments of

$20 billion to $30 billion in each year).

The rebound of buyout deal making over the past couple of years – the lifeblood of most

mezzanine investment funds – has had a salutary effect on the asset class in terms of capital

deployment. In fact, after a depressing 2009, mezzanine strategies returned in force, with 2010

coming close to equaling the previous best year of 2006, while 2011 and 2012 powered past this

high water mark. At close to $3 billion deployed, 2012 has already solidified its status as the best

year in the last ten by this measure.

Annual Mezzanine Fundraising 2003-2012 | $ Billion

Source: Thomson Reuters © 2013 TorreyCove Capital Partners

$0

$5

$10

$15

$20

$25

$30

$35

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012




Mezzanine Outlook

The prospects for mezzanine funds with respect to fundraising and capital deployment are

expected to trend in a favorable direction over the next 12 to 18 months, in lock step with the

improving prospects for the buyout asset class. The case for outperformance for the 2013 and

2014 vintages is not as easily made, however, due to competitive pressures. Salient points

relating to this and other issues affecting the mezzanine space are noted below:

• We expect fundraising to hold at or near the 2012 level over the next couple of years, with

more potential for greater fundraising due to improving dynamics for the buyout industry in

terms of increased deal activity and thinning equity contributions relative to the immediate

post-crisis years.

• As touched on earlier, the structure of buyout deals in the current market favors further

deployment of capital by mezzanine funds, as the “overequitization” trend for buyouts appears

to have run its course, meaning equity contributions for many buyout deals are now well within

the 30% to 35% range, a meaningful reduction from the 40% plus amounts that were common

in the first couple of years after the crisis.

• The high liquidity environment fostered by the Fed, along with the strong high yield markets of

the past year, are exerting meaningful competitive pressure on all debt providers, including

mezzanine, especially within the larger end of the market. In general, this should indicate a

further tightening of pricing for most, if not all, mezzanine investors.

• In a related vein, there has been some weakening of covenants. For example, no-call provisions

have experienced pressure as many BDCs have been willing to provide mezzanine capital

without such protections.

STRONG

OVERWEIGHT

MODERATE

OVERWEIGHT

NEUTRAL

MODERATE

UNDERWEIGHT

STRONG

UNDERWEIGHT


outlook >





• In general, while the environment for deployment of mezzanine capital has improved, the risk

borne by mezzanine providers has also increased, due to the high levels of total debt being

placed on companies in today’s market (see U.S. Buyout section for a discussion of leverage

levels). So the trend for the mezzanine strategy will be in the direction of maintaining pressureon pricing and covenant protection for the near future, indicating the returns to the strategy

for deals made in 2013 may be lower than usual.

• As noted in last year’s Outlook, we continue to expect that mezzanine funds that can operate

in the smaller end of the market, pursue non-sponsored deals, or develop more customized

solutions will have more pricing power and find attractive deal flow more abundant. We would

add that those mezzanine firms with positive and long-standing relationships with high quality

buyout shops should experience less in the way of deal flow shortages and severely-restricted

pricing.

Our tactical rating for mezzanine strategies is moving to “Neutral” from “Moderate

Underweight,” with an expected increasing trend in terms of capital deployment. Deal pricing

pressures are the major concern with respect to this asset class, but as noted above, certain firms

will be able to at least partially mitigate this pressure.

© 2013 TorreyCove Capital PartnersSource: Thomson Reuters

Sum of Equity Invested 2003-2012 | $ Billion

$0.0

$0.5

$1.0

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$2.5

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2003 2004 2005 2006 2007 2008 2009 2010 2011 2012



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Special Situations > Secondaries

Fundraising

Secondary fundraising roared back in 2012 after a minor lull in 2010 and 2011, following the

all-time record year of 2009, during which $22 billion in commitments were gathered by the

strategy. After two years that raised $10 billion each, the past year brought in $20 billion in fresh

funding for 14 funds pursuing secondary strategies, making 2012 the second best year on record.

Overall, the post-crisis years have been very good to secondary funds, with about the same

amount of capital raised in the past four years as in the prior nine years going back to 2000.

Though next year is likely to be another good fundraising year, it should be somewhat down from

2012, since the universe of secondary managers is small and many have recently closed on new

funds.

Investment Activity

Last year was another solid year for secondary deal making, with $25 billion in total transactions

closed during the year, unchanged from the 2011 total. Both years go down as the most active

periods, by amount, in the history of the secondary strategy. Including 2010, when about $20

billion was transacted, the past three years have not disappointed on what were high

expectations for secondary activity and there is little sign of significant slowing in the pace of

investment for 2013, given that most of the same drivers are in place and to much the same

degree.

Source: Preqin

Annual Secondary Fundraising $ Billion Secondaries Deal Volumes $ Billion

NUMBEROF FUNDS

AGGREGATECOMMITMENTS

Source: Coller Capital, Dow Jones, Cogent




Deal pricing remained essentially unchanged during 2012, with reported discounts, per Cogent,

coming in at 84% of NAV for buyout funds in the second half of the year, while the first half

showed only a slightly higher bid of 85% of NAV. As is usually the case, the median bid for

venture capital funds was meaningfully lower, at about 74% of NAV. Pricing has been highlyresilient over the past three years and what looked to be a potential downward move in the

latter half of 2011 fizzled as discounts resumed trend levels of approximately 15%. While this is

an average, it is still not unusual to see limited partner interests in good quality funds going

closer to par in today’s market. The primary factor in supporting prices is the lack of urgency on

the part of limited partners, who have been able to pick the timing and terms of sale in large

part.

Secondaries Outlook

As expected, 2012 turned out to be a solid year for secondary strategies in both fundraising and

capital deployment terms. As mentioned earlier, the key drivers to sustain momentum mostly

remain in place, so we expect the asset class to put together another robust year in 2013. Some

of the more meaningful trends and factors to note regarding secondaries over the next 12 to 18

months are as follows:

• Deal flow is expected to remain strong, but as noted, it will still tend to be a relatively

balanced market, without great selling pressure on the vast majority of transactions.

STRONG

OVERWEIGHT

MODERATE

OVERWEIGHT

NEUTRAL

MODERATE

UNDERWEIGHT

STRONG

UNDERWEIGHT


outlook >

Demand and supply in the North American PE market – LP views

Source: Coller Capital, Global PE Barometer © 2013 TorreyCove Capital Partners

0%

20%

40%

60%

80%

100%

North American

LPs

European

LPs

North American

LPs

European

LPs

There are not enough high-

quality GPs

The number of GPs is about right-

identifying/accessing the right

ones is the challenge

Too many GPs chasing too few

deals

Buyouts Venture




Regulators have provided financial institutions with more than ample time in which to

comply with new rules surrounding proprietary holdings, deleveraging mandates, and capital

requirements. Outside the financial industry, public pensions have tended to use

secondaries to manage and rationalize their portfolios rather than out of distress, andtherefore have control over exit timing. Since these two sectors still account for the lion’s

share of deal flow, pricing has held up well.

• One factor that has moved against the prospect for secondary deal flow is the reduction in

primary commitments within the “sweet spot” for secondary deal flow (see charts below).

With the dropping-off of the 2005 vintage year, which was a relatively big year for primary

commitments, and the addition of the poor 2009 vintage year, the potential amount of

secondary deal flow forecasted by trailing 3-7 year primaries has fallen by over 10%.

However, any marginal reduction in forecast deal flow based on primary commitments is

expected to be overwhelmed by dynamics regarding the banking systems in Europe(deleveraging) and the U.S. (Volcker), as well as the desire of large institutions to reduce

exposure to boom vintage years and reduce the number of managers in their portfolios.

• As expected, financial institution deleveraging provided substantial deal flow for the

secondary space in 2012, with several large, notable transactions booked during the year,

including: HSH Nordbank’s sale of approximately 47 limited partnership interests to AXA and

Lloyds Banking Group’s £1 billion sale of private equity assets to secondary specialist Coller

Capital.

Actively Trading Primaries $B

Source: Preqin, TorreyCove Research

Average Trailing 3-7 Year Primaries $B Forecasted Deal Volume 5-10% Turnover $B


$13.3$11.3

$8.9

$26.7

$22.6

$17.8

5.0

10.0

15.0

20.0

25.0

30.0

2013E 2014E 2015E

$267

$226

$178

2013 2014 2015

74

130

226

325

389419

170 165190

2003 2004 2005 2006 2007 2008 2009 2010 2011




• The deleveraging theme shows no sign of abating, in spite of the relatively improved position

of the financial sector on both sides of the Atlantic, especially in Europe, where the

immediate pressure on banks has been effectively removed by ECB actions. By various

estimates, European banks have shed over €500 billion in assets over the past year or more,but according to the IMF, this is just the beginning of what is necessary. As indicated in the

nearby chart, the IMF estimates that European banks (within its sample) will likely need to

deleverage by anywhere from $2.8 trillion (baseline scenario) to $4.5 trillion (weak policy

scenario), given the regulatory and capital adequacy standards in effect as of October of

2012. Even if these figures turn out to be off significantly (which they most likely will be), the

ground is set for an extended run of bank asset sales over the next 12 to 18 months,

continuing, and perhaps intensifying, the trend begun in 2011. While much of the

deleveraging will be accomplished via the sale of real estate-related loan books, private

equity, as a non-core asset, can be expected to play a meaningful role.

• On the investor side of the equation, potential seller interest should remain strong in 2013.

In the post-crisis environment, large institutional limited partners have been reassessing the

structure of their private equity portfolios, and many have concluded that there is significant

excess that built up in the years leading up to the crash, which took the form of too many

general partner relationships, many of them of mediocre quality. Thus, the trend in recent


Total Deleveraging by Sample Banks 2011 Q3 - 2013 Q4 $ Trillion

0

1

2

3

4

5

Complete Policies Baseline Policies Weak Policies

April 2012 GFSR

October 2012 GFSR

Source: IMF staff estimates

Note: Total deleveraging is obtained by aggregating projected asset reduction of all sample banks. For each bank, the required amount of

asset reduction is such that it allows a bank to meet all deleveraging targets, after taking into account capital measures.




years to “rationalize” private equity portfolios, which has added substantial deal flow to the

secondary universe. As an illustration of this sentiment, Coller Capital’s Global PE Barometer

for Winter of 2012 indicated that the interest on the part of LPs to cut the number of active

GP relationships within the next two years has increased across the board (since 2006).North American LPs are by far the most aggressive in this respect, with nearly half indicating

the intent to cut (compared to about 20% that wish to increase).

• As noted earlier, the prognosis for secondary fundraising in 2013 is slightly less robust than

was the case at the beginning of 2012. Though there should be a solid year of fundraising,

given the investor interest in the space, the fact that several large funds have recently

traversed the market would indicate somewhat less strength for the coming year. The

investment side should be quite strong in 2013, and given the amount of capital ready to be

deployed and the still-strong drivers of deal flow, it would not be surprising to see the next

12 months exceed the last in terms of capital deployments.

• Creativity in deal structuring will remain the order of the day, as secondary investors

continue to seek synthetic structures for transactions or develop customized cash flow

timing frameworks that allow limited partners to achieve their objectives (maintaining some

exposure to the LP interests, not having to take “too much” of a discount to NAV, etc) while

allowing secondary funds to deploy capital at reasonable rates of return.

• At the beginning of 2012, our expectation was that there would be some downward pressure

on pricing, due to the large amount of expected deal flow, pressure on institutions to sell

(Volcker and European deleveraging), and the lack of excessive capital on the supply side(though not a dearth of capital either). However, pricing remained stubbornly resilient

during 2012. Given that most of the factors which would drive larger discounts have either

moderated or stayed the same - less pressure on European financial institutions, improving

private equity portfolios of large institutional investors, etc. – our expectation is for stable

and relatively high pricing throughout 2013 (barring an unexpected shock to the system). In

effect, institutions have been willing to sell and will continue to sell, but are under little

pressure to sell, due to regulatory forbearance and assistance from governments and central

banks. For this reason, there is a pretty high floor under pricing.





• Of course, the wild card for this entire strategy remains the European debt and currency

crises. If anything is likely to trigger massive selling pressure, a sustained flare-up with respect

to either of these would be it. However, the actions of the ECB appear to have doused the fire

for now, and the probability of such blow-ups has been reduced to a much lower level than just about one year ago. The primary driver of European deleveraging at this point is the

pressure by European regulators on banks to improve capital ratios.

We are moving our rating for secondaries strategies from “Moderate Overweight” to “Neutral.”

This is based on the fact that selling pressure has been reduced significantly, in large part due to

the defusing of the immediate European debt and currency crises, and given that fundraising in

the space has been strong for the past few years, with a record year in 2012, indicating a

meaningful increase in supply of capital on a relative basis. Other factors include the expectation

that there is unlikely to be an event or action that will catalyze downward pressure on pricing,

and the moderate decrease in the amount of trailing primary limited partner interests in the

“sweet spot” of the secondary strategy. Nevertheless, we anticipate another solid year in

secondary transaction activity. We simply believe that the opportunity to earn an outsized return

has reduced on the margin compared to prior years as the asset class has become more efficient.




$0

$10

$20

$30

$40

2005 2006 2007 2008 2009 2010 2011 2012

Venture Capital

In terms of fundraising and investment activity, both of which can be characterized as at or near

equilibrium levels at present, 2012 was another steady year for the venture capital asset class.

The primary departure was with respect to exit activity, with the Facebook IPO propelling 2012 to

a status as one of the best periods for exit activity in many years. However, it wasn’t all Facebook – even without that deal, the IPO performance for 2012 was respectable, and would put it in the

league with 2010 and 2011, the two strongest years (ex-Facebook) for post-crisis IPO activity (by

amount). Our expectation for 2013 is for a reasonable, but significantly reduced, exit

environment and another stable year for investment and fundraising.

Fundraising

Despite a downbeat fourth quarter in 2012, during which just over $3 billion in new

commitments were garnered (nearly a 50% decrease from the 2011 fourth quarter), the entire

year of 2012 turned out to be fairly decent for venture fundraising. Just over $20 billion in fresh

commitments were raised by U.S. venture firms, an increase of approximately 10% from the full-

year 2011 totals. This is the third straight year with an increase, as the industry continues to

U.S. Venture Capital Fundraising Activity $ Billion

Source: Thomson Reuters & National Venture Capital Association © 2013 TorreyCove Capital Partners



0

1,000

2,000

3,000

4,000

5,000

$0

$5

$10

$15

$20

$25

$30

$35

$40

2005 2006 2007 2008 2009 2010 2011 2012

Venture Capital

climb out of the hole it fell into (along with most others) in 2009, and regain the $30 billion per

annum fundraising totals that were common for much of the decade before the crash. The

number of funds raised during 2012 was essentially unchanged from 2011 and the percentage of

existing funds within the mix (opposed to first-time funds) held relatively steady at close to 70%.

Investment Activity

Venture investors deployed capital at a steady pace in 2012, though the year ended up slightly

short of 2011, which was the best year for investment since the crisis hit. In total, $27 billion was

invested in 2012, off approximately 10% from 2011 in terms of value, but only about 6% by

number of deals. By stage of investment, the venture sector showed a good deal of balance,

with nearly one-third of dollars flowing into each of the seed/early-, expansion-, and later- stage

segments over the year. The most attractive target sector for venture investment during 2012

was software, which garnered close to 31% of all investments ($8.3 billion), followed in distant

second place by life sciences, which took in about half that amount ($4.1 billion) for the year.

U.S. VC Investment Activity $ Billion

AMOUNT

INVESTED

NUMBER

OF DEAL

Source: National Venture Capital Association© 2013 TorreyCove Capital Partners



0

100

200

300

400

500

600

2005 2006 2007 2008 2009 2010 2011 2012

Venture-backed Buyout-backed


Venture Capital

Number of U.S. Based IPOs $ Billion Number of U.S.-Based M&A $ Billion

Source: Thomson Reuters & National Venture Capital Association Source: Thomson Reuters & National Venture Capital Association

Exits

Clearly it was a solid year for venture capital exit activity. The Facebook IPO alone – which

gathered a record $16 billion in May of 2012 - would ensure that. However, even without the

impact of Facebook, 2012 turned out to be a fair year for venture-backed companies going

public: 48 other companies were listed, with disclosed deal values totaling approximately $5

billion, shy of the 2010 totals but well ahead of the poor showings from 2008 and 2009.

Extending the momentum from 2011, the M&A exit route for venture-backed companies

proved to be resilient in 2012, as 435 companies were sold in trade sales with a total

disclosed value (120 companies) of $21 billion. This is somewhat off last year’s pace of 488

deals generating $24 billion in reported proceeds (169 companies) – by about 11% in both

cases. So while Facebook provided a massive uplift to the exit performance of the venture

space in 2012, the ex-Facebook numbers provide a picture of a steady, if unexceptional, exitenvironment that has recovered from the post-crisis pit of 2009. The year demonstrates that

the markets are open to the acquisition of good quality companies, even if euphoria is not to

be found.

0

25

50

75

100

2005 2006 2007 2008 2009 2010 2011 2012

Venture-backed Buyout-backed



Venture Capital

Outlook

The venture capital arena has not been particularly dynamic over the past few years, with the

notable exception of the highly-anticipated Facebook IPO. For one reason or another – perhaps

due to its less-than-perfect execution – that IPO didn’t demonstrate a discernible “coattail effect”

or generate significant momentum on the investment or exit sides for the venture capital

markets. Nevertheless, 2012 was a balanced and steady year, and indications are that 2013 is

likely to fall into the same mold. Some of the key factors to consider for the asset class in 2013

are as follows:

• The prospects for fundraising are not expected to change appreciably from 2012, and we

expect a steady year in the $20 billion to $25 billion range.

• The visibility on changes in investment flows likewise indicates another year similar to the

past year, with somewhere around $25 billion deployed.

• In light of an improving economy and 2012s decent performance in terms of exits, 2013 is

likely to see an IPO market that continues to be open for good quality companies and a

steady M&A environment. Of course, since there is only one Facebook, the IPO exit numbers

are almost certain to decline meaningfully, but a broad-based, if moderate, supply of exit

candidates should maintain some of the post-crisis momentum that began in 2010.

• Overall, regarding fresh capital entering the industry, investment levels, and even exits, the

venture capital sector appears quite well-balanced, with no large overhangs and a

sustainable level of activity.

• One area that might be potentially out of balance is the investment stage, which has recently

exhibited a “barbell” pattern of investment – early-stage and later-stage investment

predominating, with relatively less mid-/expansion-stage capital deployed, indicating an

increased risk of a “crunch” in the middle investment stage. This bodes well for investors

that are exposed to funds that have meaningful expansion-stage capital to invest.

STRONG

OVERWEIGHT

MODERATE

OVERWEIGHT

NEUTRAL

MODERATE

UNDERWEIGHT

STRONG

UNDERWEIGHT


outlook >




Venture Capital

• The trend of industry consolidation that began several years ago will continue apace. Large,

established funds, especially those in the later-stage and growth areas, have had

comparatively easy fundraises in recent years, while many smaller firms (or those without a

long track record of realizations), have not been able to raise funds at all. Theinstitutionalization of the venture space will invariably lead to far fewer managers 10 years

from now, but there should always be some churn in the early-stage area.

• The IT sector is expected to consolidate its current leadership of investment flows, as the life

sciences and clean technology sectors deal with headwinds (regulatory/reimbursement and

performance, respectively). On a more specific basis, social media investments appear to

have passed their peak, and focus has now shifted to enterprise-oriented IT themes.

Our tactical rating for venture capital strategies remains at “Neutral.” Most of the same factors

on which our “Neutral” rating last year were based are still in place: relative equilibrium of theindustry in terms of capital flows, increasing relative fund flows to better quality managers, and

potential access to such managers by institutional investors that have formerly been restricted.

What has changed is that leadership will probably shift further to IT at the expense of life

sciences and that the exit outlook has somewhat better visibility.




0 20 40 60 80

North American Buyout

Europen Buyouts

Asia-Pacific Buyouts

North American Venture

Asia-Pacific Venture

European Venture Winter 2008-09

Winter 2012-13


Asia-Pacific Fundraising by Quarter $ Billion

Select Emerging Economies > Asia

Coming into 2012, the watchwords for Asia’s largest economies were: slower growth and

uncertainty. After several years of blistering macroeconomic growth, both China and India were

looking to manage moderating GDP growth that primarily stemmed from the troubles of their

trading partners in the developed world, as well as strengthening inflation. At the beginning of 2013, both countries made some progress on these twin goals, but China appears to have come

out the other side in better shape, with a restrained inflation rate and growth momentum by the

end of the year, at least in part due to further government stimulus. India has taken the edge off

of inflation, but it still hovers at or above the central bank target range, thereby providing a

counter to more aggressive interventionist policy by the bank to stimulate the economy. In

terms of GDP growth, India looks to be about a year behind China for a full recovery, with next

year’s growth expected to be at the moderate (by current emerging market standards) level of

5% to 6%.

Fundraising

Asia-focused funds (primarily those investing in Greater China) continue to be sought after by

institutional investors the world over, as growth in its emerging markets still outperforms

developed markets. However, the intensity of their ardour for the region appears to have cooled

somewhat over the past year, as indicated by the following graph showing investor sentiment

Source: Preqin

0

5

10

15

20

25

30

Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3

Aggregate Capital Raised

2005 2006 2007 2008 2009 2010 2011 2012

LPs Now Less Attracted by Asia-PacificBuyouts and by Venture Capital

Source: Coller Capital Global Private Equity Barometer


http://slidepdf.com/reader/full/2013-private-equity-market-outlook-final1 47/63© 2013 TorreyCove Capital Partners


regarding the region. This is not entirely surprising, as the growth prospects for China, the main

driver of the region, had slowed meaningfully in 2012, and there was even talk of a “hard”

landing for the country. Further, exit markets have come back down to earth and so realizations

by private equity investors have slowed in tandem. For 2012, fundraising for the Asia regioncame in at just over $46 billion, off nearly 20% from the prior year (just over $56 billion), and still

well off the peaks seen in 2007 and 2008. This is not altogether a bad turn of events, as the

region probably was the recipient of some less than rational euphoria during the pre-crisis years

and 2011 – 2012 probably represents a more sustainable level of funding for its still-nascent

private equity industry.

As European fundraising rebounded meaningfully from 2011 levels and the North American

buyout sector reasserted itself on the fundraising front in 2012, Asia lost some ground on a

relative basis. For 2011, Asia/ROW fundraising (predominantly China) accounted for about 21%

of fresh private equity capital raised, compared to approximately 26% for the prior year.

Furthermore, Asia beat out Europe in garnering new commitments by close to 20% in 2011, but

relinquished that lead in 2012, coming in about 10% short of the European total for the period.

In terms of the regional breakdown within total Asian fundraising, there has been little change,

with Asia (primarily Greater China and India) continuing to account for the strong majority of

investor interest in new capital commitments, with over 70% of commitments for 2012.

Composition of Funds in Market by Primary

Geographic Focus $ Billion

-100

100

300

500

700

900

North America Europe Asia/ROW

No. Funds Raising Aggregate Target

Source: Preqin

0

10

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30

40

50

60

70

80

North America Europe Asia/ROW

No. Fund Raised Aggrgate Commitments

Source: Preqin

Fundraising by Primary Geographic Focus

Q3 2012 $ Billion




Investment Activity

With respect to capital deployment by private equity investors in Asia, 2012 was a somewhat

disappointing year. At $60 billion for the year (according to ACVJ), 2012 investment came in right

at 2008 levels, and off by over 10% in comparison to each of 2010 and 2011, both reasonably

solid post-crisis years. However, a look underneath the aggregate Asia figure reveals some

nuance. For instance, investment in Mainland China, while down by around 25% from 2011

levels and about 15% from 2010 levels, still outperformed all years prior to 2010 by a wide

margin. This would indicate that, while the various issues noted earlier that are weighing on

investor sentiment towards China are having an impact, the overall positive trend for private

equity investment in the region remains on track. Unfortunately, the same cannot be said for the

other emerging power in the region: India. After clawing its way back to a respectable level of

private equity investment in 2011, the region saw flows decline by approximately one-third in2012. What’s worse is that this level is just barely above the 2009 trough and about 60% down

from India’s peak investment year of 2007. We expect 2013 private equity investment flows to

improve in Greater China, as the macroeconomic and political environments in that region offer a

higher level of certainty than existed one year ago. Further, with public market valuations at far-

reduced levels, value investors may find reason to deploy capital aggressively. For India, the

picture is more problematic, as the country seems to be suffering more from a loss of investor

confidence than simply macroeconomic concerns. Our expectation for India is a relatively flat to

slightly higher year for capital deployment.

Exits

In general, global IPO markets were relatively moribund for most of 2012, with the relative

exception being in the U.S., where volume increased year-over-year. Chinese exchanges had

some of their worst years since the beginning of the crisis in 2012; in fact, they gave up their

leadership status in the post-crisis era to the U.S. this year. In total, Chinese IPOs generated over

$21 billion in 2012, a marked decline of over half since 2011. Both the Hong Kong and Mainland

exchanges logged very poor years in IPO performance, with all three off about two-thirds or more

in terms of IPOs in comparison to 2011. Of course, the primary culprits behind this slump are the




0

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400

0

20

40

60

80

2006 2007 2008 2009 2010 2011 2012


slowdown in the larger Chinese economy and the attendant fall in share prices of publicly-traded

companies, coupled with some concerns over a menu of issues currently facing the country:

potential property bubbles, the sustainability of capital spending, accounting scandals, and the

recent leadership change. With some of these issues resolved or otherwise addressed andChina’s economy still growing above trend (in comparison to the rest of the world), there may be

a case for a more optimistic outlook on exit markets in 2013. On that front, the $3 billion fourth

quarter IPO of People’s Insurance Company on the Hong Kong exchange may be an omen of

things to come. In fact, the Hong Kong exchange generated about 50% of its total IPO amount

for 2012 from the fourth quarter alone, indicating signs of potential life for 2013. The Mainland

exchanges, however, saw no such rebound in the fourth quarter, meaning a robust, broad-based

IPO resurgence in 2013 is still an open question. The M&A markets for Asia-based private equity

fared similarly to the IPO markets in terms of value (though the volumes held up better),

registering a material decline from what was a relatively strong year in 2011 (the best year forprivate equity M&A since the crisis, in fact). For 2012, private equity M&A flows shifted down to

around 225 deals and just over $30 billion in value from over 250 deals and around $50 billion in

value for the prior year, a relatively steep decline of over 60% year-over-year, by value. On the

positive side, both the value and volume of private equity M&A in 2012 came in higher, if just

barely, than for any of the years since 2007, except 2011.

Priced IPOs – China: Mainland Exchanges (Shanghai & Shenzhen) $ Billion

Source: Bloomberg; China Daily © 2013 TorreyCove Capital Partners

IPOCOUNT

AMOUNT OFDEAL FLOW




Outlook

Developing markets, the darlings of the investment world for much of the post-crisis era, lost a

bit of their luster in late-2011 and 2012. As anticipated, growth in China slowed appreciably, and

there was some concern over what the likely depth of the decline in GDP would be for 2012. It

appears that the rumors of a possible “hard landing” were exaggerated, as the region’s economy

expanded by an estimated 7.8% for the full year, including a hot fourth quarter. So far, estimates

for 2013 are signaling GDP growth of over 8% for the year. The inflation rate, which was of such

concern in 2011 (trending at over 6%) and remained an issue at the beginning of 2012 (trending

over 4%), is well within control at close to a 2.5% annual pace of increase as of December 2012,

indicating the government’s concerted efforts to stymie price increases – along with the cooling

economy – have been largely successful.

Once again, the scene in India looks less rosy. The region’s GDP growth rate, which has

disappointed since 2011, turned in a mediocre performance in the third quarter of 2013 – a 0.6%

increase from second to third quarters – indicating that the economy appears to be running low

on steam. After a decent showing of nearly 7% in 2011, India’s 2012 GDP growth is expected to

come in around 5.5% on an annualized basis. Estimates for 2013 are in the same range.

Meanwhile, rupee inflation remains stubborn, with annualized rates of over 7% for nearly all

measured periods in 2012, albeit down from the troubling levels of 9% to 10% that were regular

occurrences throughout 2011. With the economy stalled and the Reserve Bank of India on an

easing trend, the wild card of inflation remains a major concern and one of many potential

headwinds for the Indian economy.

Overall, emerging economies will be more of a mixed bag in terms of performance in 2013, with

China looking to maintain its status as the leader, based on its relatively low inflation and

continuing macroeconomic growth trend, which appears to have stabilized at the end of 2012.

India will be fighting inflationary fears while attempting to spur its economy to higher growth, so

the outlook there is more opaque.

STRONG

OVERWEIGHT

MODERATE

OVERWEIGHT

NEUTRAL

MODERATE

UNDERWEIGHT

STRONG

UNDERWEIGHT


outlook >





China

• After a solid fourth quarter performance, the Chinese economy appears to have gained some

momentum after a year that was somewhat down by its more recent standards. While

achieving regular 10% GDP growth year-after-year will soon be out of reach, the consensusgrowth rate of 8% or more for next year looks reasonable.

• RMB-denominated funds, which have been the rage in China since their introduction in

2010, achieved parity with U.S.-dollar-denominated vehicles in the fundraising races over the

past two years, and even bested the latter in some periods. By some estimates, there is

nearly $80 billion committed to such funds, which are required to invest all of their capital in

companies operating in the Chinese domestic markets (possible loosening of this

requirement has been discussed). RMB funds have much shorter lifespans than their non-

RMB counterparts, and are therefore more reliant on strong capital markets to achieve

relatively rapid exits. The slump in China’s exit markets throughout 2012 is likely to bring

pressure on many of these funds, as they are not able to effectively exit while markets are

down and while time is running out on their formal lifespans, especially for those raised in

2010. Absent a regulatory intervention or a rapidly-strengthening IPO market, many of these

funds may be forced into less than ideal exits sometime in the next two years.

• The all-important manufacturing sector in China appeared to awaken toward the end of

2012, which bodes well for economic growth in 2013. The January 2013 HSBC/Markit PMI

reading, which had been below 50 (indicating declining activity) for much of 2012, came in at

51.9, the most positive reading in two years going back to January of 2011. Further, themeasure has been on an uptrend for five consecutive months and has been in positive

territory for three. Interestingly, the source of renewed vigor in the manufacturing sector

looks to be primarily domestic demand, as export growth has remained relatively flat or

negative in 2012 and going into 2013.





• The valuation of public companies on the Chinese exchanges is having a variety of effects

within the China-focused investment world. Price/earnings ratios, soaring to 50x or more

during the 2007 peak, have fallen dramatically over the intervening years, and are now at

levels between 10x and 20x, more or less on a par with the valuations of their developedworld counterparts. This has had a negative effect on RMB-denominated funds, which have

seen their primary exit route obliterated until a rebound in the public markets takes hold,

which has in turn made fundraising a much more difficult prospect. Many high net worth

investors in China – expecting quick turnarounds on their investments – have now begun to

flee pre-IPO strategies. All of the above-mentioned factors should play well to more

traditional private equity investors in the coming year, as lower public valuations may have

the effect of moderating price expectations relating to private Chinese companies and the

competition from high net worth investors and RMB funds should be less intense.

• The Chinese economy continues to rely heavily on fixed capital investment flows, in spite of

pronouncements by the government that it wishes to encourage the economy into a more

balanced status whereby domestic demand accounts for a larger percentage of growth.

While there is some indication that domestic demand has grown in the past couple of years,

2012 saw relatively flat domestic demand growth, most likely as a result of the slowing GDP

trend that year and relative weakness in exports and manufacturing activity.

• As a response to the slowdown in the economy during the first half of 2012, the National

Development and Reform Commission announced a plethora of approved projects that

would be funded by various government entities, with a focus on traditional infrastructure

(roads, airports, rail, subways) as well as clean energy projects and heavy industrial

expansions. The estimated value of the programs is close to $160 billion, and the impact of

these projects appears to have begun to show up in the fourth quarter 2012 GDP growth

figures. For perspective, the most recent stimulus program weighs in roughly one-quarter

the size of the massive 2008-2009 stimulus rolled out by the government to stave off a

recession.





• It appears that the real stimulative action going into 2013 and beyond will come from the

local government coffers. These entities have apparently green-lighted various projects

totaling over $1.8 trillion. It remains uncertain whether all of these projects will actually see

the light of day, but the impact will be spread over the next three to five years in any case.• With some freedom of operation due to more restrained inflationary pressure, the People’s

Bank of China is likely to pursue a more expansionary monetary policy in 2013, in order to

provide momentum for economic and employment growth. The bank cut both reserve

requirements and the benchmark rate more than once during 2012 as signs of weakening

economic performance became apparent.

• In response to a fraudulent IPO listing in 2012, and the resulting weakening of confidence by

investors, the China Securities and Regulatory Commission (“CSRC”) recently announced its

intention to perform an extensive review of all companies currently in queue for an IPOlisting – some 880 firms. Companies are being encouraged to review themselves and

voluntarily withdraw from the IPO track if their performance has not been as strong as

originally estimated or if there are other factors that argue against an IPO. Market observers

estimate that the CSRC wishes to cull the list of IPO candidates by approximately 300, and

that private equity-backed companies could be a major target group. The effect of this policy

is likely to manifest in two primary ways: a more manageable, and perhaps reliable, universe

of IPO candidates and a more robust secondary and trade sale environment for private

companies in China. Both of these would be clearly positive changes, especially the

development of a robust trade and secondary sale market – currently in a less than idealstate – as an alternative exit route for private equity-backed companies.

Our tactical rating for China will remain at “Moderate Overweight.” Key factors in this rating

include: a rebounding macroeconomic growth picture, significantly more attractive company

valuations in the public markets (which is hoped to extend to private markets), the resolution of

the leadership change process, controlled inflation, and the medium-term growth prospects for

the country.





India

• As noted earlier, the Indian macroeconomic picture declined significantly in 2012 and there

is not a great deal of momentum going into 2013. GDP growth of between 5.5% and 6% for

the past year will represent one of the worst periods for the economy in the past ten years.Further, most estimates for 2013 growth are coming in at under 6.0% (many revised

downward after a poor second half GDP growth showing) and do nothing to improve

confidence in the ability of the Indian economy to resume the strong growth that was the

norm just a few years ago. Currently, a recovery in excess of 6% growth is now not expected

until 2014.

• As anticipated last year, the RBI was able to restrain burgeoning inflation (9% or more in

2011) – to a point. As a result of some tightening by the central bank and a slower economy,

the inflation forecast has now fallen to just under 7% and is expected by the central bank to

remain range-bound near this level for the next year or so. In spite of some cooling, the

inflation rate remains a concern, as the RBI recently announced loosening moves – including

a reduction in its repurchase rate (from 8% to 7.75%) and a minor cut in its required reserve

ratio. With inflation expected to run only moderately under the repurchase rate and the RBI

now focused more intently on jumpstarting the economy, higher future inflation is a real risk

in the next two to three years.

• Also as anticipated, Indian exports – a very important segment of the overall economy for

the region – fell meaningfully for much of 2012. For the April through December 2012 time

frame, exports, in dollar terms, were off by approximately 5.5% and off nearly 2% for themonth of December (compared to December 2011). This comes on the heels of a strong

2011 and is implicated in both the overall cooling of the economy and the worsening trade

balance situation currently affecting India. In December of 2012, the government

announced the extension of 2% export loan subsidies to Indian industry, also expanding the

subsidy to the important engineering sector. It is hoped that such measures, in addition to a

slow but steady recovery by the developed world, will eventually reinvigorate Indian export

sector performance.





• One very positive development for India came from the manufacturing sector, which appears

to have avoided a potential slump that looked imminent as of the end of 2011. With the

HSBC India Manufacturing PMI indicator reading 54.7 in December of 2012 (after a relatively

solid 53.7 in November), there is certainly some wind at the back of the sector. Overall, PMIreadings have been in positive (growth) territory for the past four years. Increasing strength

in the manufacturing sector can be expected to provide one of the few positive boosts to the

Indian economy in 2013 and beyond.

• The equity markets in India turned in a better-than-expected performance for 2012, with a

gain of approximately 18% (January 2012 to January 2013) for the Sensex index (Bombay

Stock Exchange). With a price/earnings ratio hovering at or below its current level of 18x

(Sensex) for much of 2012, value plays will continue to be enticing to foreign and domestic

investors.

• After a worse-than-expected year in terms of growth, India appears set for a repeat of sub-

par economic growth for 2013. While not out of control, inflation remains on the radar as a

potential problem, mostly in that it may serve as a barrier to more aggressive action by the

RBI to stimulate the economy. Export performance was disappointing in 2012, but may see

some improvement in 2013 due to improved (or stable) conditions with respect to India’s

most important trading partners. Public market valuations and manufacturing sector vigor

both serve as positive drivers going into 2013.





• 2012 saw a major decline in private equity investment in India, a drop which looked to be out

of proportion to the dip in GDP growth or other macroeconomic indicator deterioration.

Private equity investment in India (as reported by ACVJ) flagged by over 25% compared to

the prior year’s level, and was the worst showing since 2009. While the magnitude of theIndian slowdown was larger than China’s, it looks most likely that private equity investors are

shying away from the region due to larger, and longer-term, issues. These would include a

general lack of confidence in the government’s ability to manage the economy (and itself),

drive needed reforms, or deal with the notoriously inefficient bureaucracy that has

hampered Indian growth for years. While private equity investment is likely to pick up in

2013, these structural issues, if left largely unresolved, will continue to maintain a ceiling on

the level of private equity investment the country is likely to garner.

Our rating for India will shift to “Neutral” from “Moderate Overweight” due to the lack of strong

momentum for economic growth in 2013, inflation remaining well over the government’s target

range, a sluggish export sector, and persistent structural problems that do not seem close to

being addressed. On the brighter side, valuations in the Indian public markets remain at

relatively attractive levels, and should prove an enticement to private equity investors (if the

valuations are translated to private companies) once the economy shows some more signs of

strength, perhaps toward the end of the year and going into 2014.




Select Emerging Economies > Brazil

Brazil had a more difficult year than expected in 2012, with GDP growth surprisingly on the

downside and inflation that appears in control but not at comfortable levels. Given the policy

stance of the central bank and the weakening of the exchange rate, the ground for a recovery in

2013 looks to be in place, but the year is not expected to be a return to the rapid growth seen in2010 and earlier years. The most likely path for Brazil calls for a slow improvement over the next

two years, with a persistent threat of inflationary pressures ever in the background.

Overview

In terms of economic growth, Brazil has had a tough run of late. After a relatively lackluster year

in 2011, with GDP growth under 3%, 2012 could not manage to break out from a GDP growth

rate of 1%. All of this after a stunning year in 2010 (over 7%), when the region’s growth was in

league with that of China. After downward revisions, the consensus estimate for growth in 2013

is just over 3%, with a slightly more robust performance in 2014. Further, inflation has proven

resilient. While the Bank of Brazil’s tightening actions managed to bring the rate down from its

highs of over 7% in 2011 (6.5% in December) to a low of just under 5% midway through 2012, the

rate has bounced back up as the central bank has been forced to ease in the face of sluggish

economic growth. At a current rate of near 6%, and with estimates for 2013 of a rate in the mid-

5% range, inflation is likely to be a confidence-eroding factor for the Brazilian economy for much

of the next year or two. One factor from last year that was weighing heavily on the

manufacturing sector, and hence on the larger economy, was the strength of the Brazilian real in

relation to the U.S. dollar and other major currencies. There was a major weakening of the real

in 2012 as a result of lower economic growth and the resumption of a more accommodative

monetary policy, with the USD/Real exchange rate moving from 1.65 real near the beginning of

2012 to over 2.0 real by the end of the year. This currency weakening should provide some

needed help to the export and manufacturing sectors over time.




Fundraising

Private equity investors continued to talk Brazil up during 2012 and interest remains high in this

large emerging market. The problem is that positive talk did not translate into capital

commitments for 2012. After a strong year on the fundraising trail in 2011, where 17 funds

closed on about $10 billion in fresh capital, the bottom more or less fell out in 2012, when 7

funds were able to gather only $1.4 billion in new commitments. However, it is important not to

read too much into this, as there are good reasons for the decline, including the fact that a few

large funds moved through the market in the one or two years leading up to 2012, historical

fundraising for Brazil tends to come in at less than $2 billion in most years, and the supply of

capital at this point is most likely in rough balance with quality deal flow (or perhaps

oversupplied). Of course, the overall economy of the region, which weakened significantly in

2012, probably had something to do with the dip in fundraising as well.



Fundraising $ Billion Brazil Current Account Balance $ Billion

NUMBER

OF FUNDSAGGREGATE

FUNDRAISING

Source: World Bank & Trading EconomicsSource: Preqin

0

4

8

12

16

20

2006 2007 2008 2009 2010 2011 2012

-60

-50

-40

-30

-20

-10

0

10

20

2 0 0 3

2 0 0 4

2 0 0 5

2 0 0 6

2 0 0 7

2 0 0 8

2 0 0 9

2 0 1 0

2 0 1 1

2 0 1 2




Exits

For the Brazilian IPO market, a great deal of hype at the beginning of 2012 – when over 40

companies were anticipated to go public during the year – gave way to something like despair, as

the market all but collapsed during the year. Only three companies were able to float shares in

2012, gathering less than $2 billion in total proceeds, a steep decline in comparison to the prior

two years, each of which had about three times the number of listings and more than double the

total proceeds. And none of these years come close to the peak of 2007, when over 60 firms

listed on the Bovespa and cleared close to $25 billion in funding. The reasons for this poor

performance vary, but near the top of the list is the poor performance of the Brazilian economy.

Government policy has not helped, either. In order to cool down hot offshore investment flows

that were causing the real to appreciate strongly (thereby weakening exports and

manufacturing), the government instituted taxes on capital flows and used regulatory measuresto attempt to stem the tide. This appears to have worked, as the real has depreciated

significantly, but it also managed to choke off foreign investment, which is the life blood of the

Brazilian IPO market. Currency depreciation, and the active government efforts to manage it, as

well as investor perception that many Brazilian IPOs are over priced considering their risk, have

also been implicated in the lack of IPO activity for 2012. Once again, there are predictions of a

strong rebound in the IPO markets for 2013, and several large firms are planning to go public (the

insurance division of Banco do Brasil and a division of Gol Linhas Aereas). Further, the

government has signaled a shift to a more investor-friendly posture in 2013. The recently

announced IPO of communications technology company Linx (over $200 million) may be aharbinger of a better market in 2013. However, a dose of skepticism is in order, given that the

Brazilian economy is still not back to strong growth and many of the structural problems

inhibiting IPO flow remain in place. In a sign of continued maturation on the part of Brazilian

markets, M&A had a solid year, with over 600 deals being completed in the first three quarters of

2012, indicating close to a 6% increase over 2011 deals.





Outlook

In a year where other major emerging market growth stories like those of China and India lost

some of their upward trajectories, Brazil was no exception. In fact, in many ways the region

performed even worse than its emerging market brethren, certainly with respect to GDP growth.

Of course, the drivers of long-term growth and wealth creation remain in place: abundant natural

resources that can be developed, a young and upwardly mobile work force, relative financial

stability in comparison with prior periods, and a growing middle class. With respect to the

nearer-term prospects for the country, a slow recovery, beset by potential problems associated

with foreign trade volatility, currency fluctuation, and inflation, seems to be the most likely

course for 2013. Our outlook for 2013 and into 2014 notes the following key elements:

• As it did in 2012, the Bank of Brazil in the coming year will have to navigate a narrow channel

between fostering economic growth and keeping a lid on inflation. At an annual rate of closeto 6%, Brazil’s current inflation sits near the top end of the central bank’s stated comfort

zone. During 2012, the bank had significant room to ease, as it had just completed a

tightening trend throughout 2011 in order to combat inflation.

STRONG

OVERWEIGHT

MODERATE

OVERWEIGHT

NEUTRAL

MODERATE

UNDERWEIGHT

STRONG

UNDERWEIGHT


outlook >


4.5

5.5

6.5

7.5

2 / 1 1

4 / 1 1

6 / 1 1

8 / 1 1

1 0 / 1 1

1 2 / 1 1

2 / 1 2

4 / 1 2

6 / 1 2

8 / 1 2

1 0 / 1 2

1 2 / 1 2

14000

16000

18000

20000

22000

24000

26000

28000

Jan/11 Jan/12 Jan/13Jul/12Jan/12

Brazil Inflation Rate Brazil Exports by month (USD million)



• With a current Selic rate of 7.25% and inflation apparently stable but sticky, further

monetary easing is not a given for 2013. The Bank of Brazil may have less room to maneuver

in terms of simulative rate cuts in the coming year, so a relatively stable trend for interest

rates is expected.• Macroeconomic growth for the country is expected to be moderate – around 3.5% for 2013.

Given the importance of exports to the Brazilian economy, continuing marginal improvement

on the economic growth front for much of the developed world will be critical to the region’s

growth prospects this year. The apparent rebound of China to stronger growth should

provide some positive momentum, however, especially on the commodity export front. The

depreciation of the real over the past year should also provide some tailwind to export

growth for 2013. Overall, Brazil is in a better position at the beginning of 2013 to deliver

economic growth than it was at the beginning of 2012. Major downside risks involve a

renewed slump in growth in China, a more general slowdown in world growth, or an

unexpected shock from the EU.

• Inflation should remain stable and hover around 6% in 2013, as the central bank has

indicated its willingness to embark upon material rate increases once the inflation rate

breaks out of its target range.

• Brazil’s critical export sector weakened during 2012, dipping 5.3% on a year over year basis.

While overall slackened world demand was implicated, a 20% drop in exports to Argentina

was a major factor. The government has taken measures to boost export growth, most

importantly in terms of weakening the real. The combination of currency depreciation andimproving economic growth in much of the world, particularly China, offer some hope to a

strengthening of export performance next year.

• Fundraising by private equity firms is not expected to come close to 2011 levels, but should

come in better than 2012’s showing.






• Private equity investors should continue to invest capital at a fairly regular pace in 2013, as

interest in the region remains high. The continuing IPO doldrums may eventually have some

impact on the pricing of private equity deals in Brazil, which would serve to spur even greater

deployment of private equity capital in the region. The relative strength of the M&A exitroute should serve to boost investor confidence that realizations can be generated even

absent a robust IPO market.

• On a long-term basis, we continue to see infrastructure investments as quite attractive to the

private equity investor. This is based primarily on the relative deficiency of the country in

terms of all types of infrastructure, but especially in regard to the transportation sector. It

has become ever more clear over the past few years that the inadequacy of transport in

Brazil has created supply bottlenecks that have seriously impacted its actual and prospective

growth rates. Eventually, this will become even more urgent priority for government and

business interests, who will wish to more effectively co-opt private capital into modernizingprojects.

Our tactical rating for Brazil remains at “Neutral,” with a cautiously optimistic outlook for a more

bullish rating by the end of next year. Several factors have moved in the country’s favor over the

past year, including the depreciation of the real, stabilization of inflation, and improving

economic prospects for many of its important trading partners. The cooling of public market

valuations continues to be a positive factor in terms of generating foreign investor interest. The

major challenges for Brazil in 2013 will be related to boosting export performance, generating

GDP growth momentum, and keeping a wary eye on inflation.




TorreyCove Capital Partners is a global alternative investments specialist. Our core mission is

to partner with our clients to create world class customized investment solutions thatappropriately mitigate risk and enhance long term performance potential. As a client-

oriented firm, we create value through a combination of private equity market intelligence,

objective advice, insightful investment guidance and selection, and innovative investment

2013 private equity market outlook final1

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