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Watson Wyatt / INDOCAM

Alternative investment review relating to the United States marketplace

Prepared by:

Investment ConsultingWatson Wyatt Partners(Actuaries & Consultants)3 March 2000

The purpose of this Report is to examine and analyse in detail the alternative investment market within the United States as set out in the terms of reference from INDOCAM in a letter dated 21st

January 2000.

Section Page

1 Introduction 1

2 Private market strategy overviews 3

3 Public market strategy overviews 19

4 Future growth trends 33

5 Performance summary 38

Appendix

A References 39

B Figures and tables 41

The report has been produced for your own internal business purposes only and may not be used for any other purpose or disclosed to any third party without the prior written consent of Watson Wyatt Partners.Actual future results will vary from any projections given in this report. Watson Wyatt Partners have based any projections given on certain assumptions and parameters. These assumptions and parameters include those which may be influenced by management decisions, changes in law and regulations and external economic factors.

The report is based on information available to Watson Wyatt Partners as at the date of this report, or as otherwise notified to you in any earlier communication, and takes no account of developments after that date.

Watson Wyatt / INDOCAM Survey

1.1 In this paper, we provide an analysis of the growth trends and investor appetite in the United States for non-traditional investment strategies, also

commonly called 'alternative investments'.

1.2 As part of our ongoing consulting work with clients in this area, Watson Wyatt commonly categorizes the different alternative investment strategies into three types: public market strategies; private market strategies; and real estate/natural resource strategies. In summary, these three basic types of strategies differ in the following ways:

Public market strategies are characterized by the fact they are exchange listed and traded on a daily basis on various markets around the world. The market value of such securities can be determined at any given point in time or, in other words, these strategies all have a quantifiable ‘price’.

Private market strategies differ from public market driven strategies in that there are no exchange traded markets for these securities and, thus, the price of the investment is not known precisely until the asset is actually sold. Estimates of the value of the securities can be made, however, by using book value or market value proxies such as the price of comparable investments. However, in this area of the market, no two securities are ever exactly the same, leading to uncertainty in the valuation of such assets throughout their life.

Real estate/natural resource strategies differ from the above strategies in that they involve the purchase and sale of physical assets, i.e. land, buildings and natural resources, as opposed to purely financial assets (stocks, bonds, etc).

1 Introduction

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PUBLIC MARKET STRATEGIES

REAL ESTATE / NATURAL

RESOURCES

PRIVATE MARKET STRATEGIES

THE ALTERNATIVE INVESTMENTS UNIVERSE

Private Real EstateREITs

Commodities/EnergyTimber

Venture CapitalBuyouts

Distressed DebtMezzanine

Hedge FundsMulti-Strategy Funds

ArbitrageOption Overlay

Managed Futures

1.3 While we will focus primarily on private and public market strategies, it is worth noting that the market for real estate type investments is significant in the U.S. and may be an important point on the 'experience curve' leading institutional investors to expand their investments into other alternative strategies. It is also important to note that the categorizations made by Watson Wyatt are not universal. In fact, discussions on alternative assets often include mention of asset classes such as emerging markets, both equities and debt, and high yield fixed income investments. While the investor appetite for these assets may not approximate the demand for more traditional securities, it is our belief that the use of these assets classes is prevalent enough among institutional investors as to make them more traditional than alternative. Again, it may be experience with these once alternative strategies, however, that has led investors to expand their opportunity set to include the alternative strategies outlined above. Indeed, many industry observers predict that the significant expansion into areas such as hedge funds and venture capital will make these areas similarly commonplace in institutional portfolios and effectively move them off the alternative spectrum.

1.4 Within the scope of this paper, we will focus our analysis on the perceived trends in the private and public market strategies, more specifically venture capital, buyout and mezzanine financing and hedge funds. Section 2 addresses the private market strategies in greater detail, while Section 3 covers the public market approaches. Within each of these areas, we will offer a general overview of the particular strategy, more clearly define the current size of these alternative markets and highlight the historical growth in assets and investor demand. In Section 4, we will offer perspective on the factors and influences that we believe may drive future demand in these areas. Finally in Section 5, we will provide historical performance statistics generated under each of these alternative investment approaches.

1.5 Private equity is a broad term used to encompass the investment in non-public companies ranging from seed or start-up venture capital firms to the restructuring of mature, private businesses. Common subclasses of the private equity universe include venture capital, leveraged buyouts, distressed securities, and mezzanine financing. Each of these subclasses offers a unique tradeoff of risk and return and has its own distinct capital cycle. The key characteristics of private equity investing are that it requires an equity participation, there is value added through active, ongoing involvement by fund managers with the portfolio companies, and the investment orientation is of a long-term nature. Private equity investing profits from the basic building of business value.

2 Private market strategy overviews

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1.6 Institutional investment in private equity began largely in the 1970s and was initially concentrated in the venture capital sub-segment of the market. The corporate restructuring boom of the 1980s carried over into the private market with the leveraged buyouts of more mature companies. Today's restructuring transactions involve less use of leverage and more innovative equity financing techniques to enable the ownership of privately held companies to pass from one generation to another, or enable a company without access to the public financing arena to continue to grow and expand their business.

Market size

1.7 In the United States, the private equity markets are over six times larger than the public equity markets and represent a large portion of untapped capital market wealth. According to Dun and Bradstreet, there were 156,000 U.S. companies with revenues of $10 million or greater as of 1998. Of these, 134,000 are private while only 22,000 are public. The institutional investor has focussed predominantly on the 4,300 public companies with annual revenues of $250 million or more; total pension investment in private equity amounts to only 2% of assets. As a result, the private equity markets are still strikingly inefficient.

Source: Dun & Bradstreet’s Market Identifiers Database. Courtesy of Abbott Capital.

Public21,523

Private134,498

156,021 Companies (as of 12/98)Revenues $10 million and above

Revenues$10 - $25 Million


RevenuesOver $250 Million

Public6,574

Private80,019

Public7,454

Private41,604

Public3,191

Private8,134

Public4,304

Private4,741


1.8 Looking forward, private equity investments are expected to provide a return premium to the S&P 500 on the order of 500 to 800 basis points. This return premium is substantial, particularly in light of the more modest return expectations for the public markets going forward. While traditional asset allocation techniques cannot accommodate the valuation difficulties inherent in private equity investment, it clearly offers the potential to offset the drag of a low-return investment environment for public securities.

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Market demand

1.9 Estimates of current demand for private equity investments vary significantly across firms tracking the industry due to the very nature of private equity and various levels of disclosure. Depending on which source is used, the total demand for private equity in 1999 ranged anywhere from $75 billion to $110 billion. Figure 1 shows the significant growth in demand for private equity investments, broken down in to the major private equity classes of venture capital and buyout and mezzanine financing, over the last five years and the slight overall slowdown witnessed in 1999. This slowdown was due almost entirely to reduced demand for buyout capital, which fell by over 30%. Other segments of the private equity universe posted very strong growth numbers, led by venture capital, which increased by over 30%. Mezzanine financing also grew by roughly 50% in 1999, though the committed asset base is still very small in relative size, standing at just over $4 billion at year-end 1999.

Figure 1: Demand for U.S. Private Equity Investment (1995-1999)

Source: Venture Economics.

1.10 Figure 2 highlights private equity demand by major investor categories. Here we note that the private U.S. pension fund sponsors represent the biggest segment of buyers in the private equity market. The second largest demand over this observed period has come from corporate (non-pension) buyers, while high net-worth families and individuals and public pension funds have also placed significant assets in private investments. Other segments, including banks and insurance companies, have not generated the same levels of interest in the markets over this period.

Figure 2: Demand for U.S. Private Equity by Investor Type (1990-1999)

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1.11 While the figures above represent the overall growth witnessed in private equity over the past ten years, it may also be telling to look at changes in plan allocation levels as a predictor of future private equity growth sources. According to a recent survey by Pensions & Investments, allocations to private equity are up in almost every category they track and from perhaps unexpected sources. Looking at Figure 3 below, we note that the allocation to private equity among public pension plans is up dramatically, particularly among the top 200 plans (2.6% vs. 1.7%). Notable increase is also seen among the smaller union plans, that have raised allocations by 1.1% over the past year. Surprisingly, the top 200 corporate plans have actually reduced their allocations to private equity, though this may represent actual investment levels and not commitment levels. We will later discuss the problems plans face in investing their full private equity allocations in greater detail.

Figure 3: Increasing Allocations to Private Equity

1999 Allocations

0%

1%

2%

3%

4%

5%

Top 1000Plans

Top 200Plans

Bottom 800Plans

1998 Allocations

0%

1%

2%

3%

4%

5%

Top 1000Plans

Top 200Plans

Bottom 800Plans

Source: Pensions & Investments, January 2000.

1.12 Despite having lower percentage allocations, public plans represent some of the largest investors in the alternative asset classes. According to the same industry survey, seven of the ten largest investors in private equity are public plans, with the largest, the Michigan Treasury, having over

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Corporate Public Union

$4 billion invested in the asset class. The largest corporate investor in private equity is General Electric, also the second largest U.S. corporate plan overall, with over $3.2 billion invested.

1.13 While we have seen how the overall private equity markets have grown substantially over the recent past, it is useful to look more closely at the trends in the subclasses of venture capital, buyouts and mezzanine financing to better understand the dramatic growth in the combined private equity markets.

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Venture capital

Definition

1.14 The term 'Venture capital' refers to the financing of new companies, often in the initial stages of development, which may offer new and innovative products or services. Investment may be made in the start-up phase of a new business or in a company with a limited business history that needs substantial capital to achieve operating economies and long-term financial viability. From these initial stages, investment typically continues until an initial public offering (IPO) or acquisition provides a payout to investors. Issues to be addressed at the portfolio management level include each company’s stage of development, financial and operating leverage, sensitivity to business cycles, regulatory considerations, and industry diversification.

1.15 Venture capital is founded in a fundamentally strong economic rationale in that it provides the seed capital for many start-up companies that have exceptional growth prospects. In addition, venture capitalists typically play a substantial role in the management of the companies in which they are invested, thereby affording a level of direct control not commonly offered in the public markets. Venture capital also has a low observed correlation with other asset classes, though the statistics with respect to volatility and correlation are suspect due to the nature of the valuation principles applied in the venture capital industry. Given that there are no exchange traded prices available for venture-backed firms, estimates of total portfolio value and thus portfolio returns are inherently smoothed compared to portfolios comprised of securities whose prices can fluctuate on a daily basis.

1.16 Yet, risks are correspondingly high: 40-50% of investments typically result in partial or total losses and 30% of investments break even or provide only a modest return. The performance of this strategy also depends upon the supply and demand for venture capital financing and the viability of future liquidation and payout strategies. Finally, venture capital funds face greater reliability on strong business cycles, a relative lack of liquidity, and high management fees.

Venture capital growth

1.17 Looking at the current demand for venture capital, however, it would appear that investors are seeing that the potential returns significantly outweigh these inherent risks. In fact, venture capital investments have continued to grow rapidly over the recent past, reaching an impressive $51.6 billion in 1999, an increase of over 30% from 1998 levels. Interestingly, this significant increase in committed capital has come with a relative slowdown in the additional number of funds in the marketplace, as highlighted in Figure 4. Whereas committed capital has been growing at an average rate of 58% over the last three years, the number of funds has increased by only 24%, with less than 40 new funds introduced in 1999.

Figure 4: Growth in U.S. Venture Capital (1990 – 1999)

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1.18 Further analyzing the sources of this growth, we can see that the private U.S. pension funds have been the most active investors in venture capital over the past ten years. Yet, what is also interesting is to look at how the demand among investor types changed during the 1990s. Figure 5 below reveals how the private pension funds became the leading investors in venture capital over the past decade, but that an acceleration in relative demand really came only in the last half of the decade. Prior to 1995, non-pension corporate investors were the single largest category, while foreign investors were also heavy buyers. We can also see where the public pension funds have accelerated their investment activity since 1995, while banks and insurance organizations have maintained relatively consistent levels of investment.

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Figure 5: Commitments to U.S. Venture Capital by Investor Type (1990-1999)

Venture Capital: Commitments by Investor Type1990-1999

5.0% 3.3%

18.6%

25.4%

7.7%

12.9% 11.7%

5.2%

10.1%

0%

5%10%

15%

20%25%

30%

Banks Insurance Corporate(Non-P ension)

P rivateP ensions

P ubicP ensions

Family/Individuals

Endowment/Foundations

Intermediary Foreign/Other NEC

% o

f Tot

al C

omm

itmen

ts

Venture Capital: Commitments by Investor Type1990-1994 versus 1995-1999

4.8% 5.0%

19.2%

13.7%

5.9%9.0%

12.0%

3.7%

26.8%

5.0%3.1%

18.6%

7.9%

13.3% 11.7%

5.4%8.7%

26.4%

0%4%

8%

12%16%20%

24%28%


P rivateP ensions

P ubicP ensions

Family/Individuals



% o

f Tot

al C

omm

itmen

ts

1990-1994 1995-1999


1.19 Investments in venture capital are notably top-heavy, with the top 200 U.S. defined benefit plans having over $17 billion invested as of year-end 1999. This represents a substantial 42% increase over 1998 levels, when the top 200 plans had invested $12 billion. Further examining the top 200 plans, we note that the use of venture capital among the largest plans is widespread, with 89 plan sponsors (44.5%) currently investing and with some plans putting as much as $1.2 billion in the market.

1.20 The increased attraction to venture capital in the U.S. is due in large part to the overwhelming success of the Internet and technology driven venture companies. As the Internet companies are cashing in on the market’s seemingly insatiable appetite for new public offerings, the venture fund backers are generating impressive returns. The increased turnover of venture investments is also related to this market appetite. As venture-backed firms go public at an increasing rate, the demand for and use of invested dollars has also increased. Money is being returned to investors at a faster rate than in previous years and at higher multiples. This success and increased flow through the markets has presented the institutional investor with not only more reasons to invest, but also more opportunity.

1.21 As a result, the make-up of the venture capital market should be closely examined. With now over 38% of all venture capital allocated to Internet-specific companies, investors must be

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increasingly aware of the levels of sector exposure inherent in their allocations. Investors must also recognize how rapidly these sector shifts are occurring in the venture capital markets and how these sector demands are driving overall growth. The level of financing for Internet-specific ventures, for instance, grew by 471% in 1999 alone, while computer hardware and electronics financings also posted 100%+ growth numbers for the year. Clearly these are the areas that are driving the impressive growth in venture capital, but it must also make investors question the degree of diversification involved in what is usually a risky asset class and whether there is simply too much capital currently chasing venture deals.

Figure 6: Venture Capital Financing by Industry Sector (1999)

Medical/ Health5%

Semiconductor/ Electronics4%

Consumer Related4%

Biotechnology2%

Computer Hardware3%

Industrial/ Energy2%

Other Products9%

Internet Specific38%

Communications17%

Compute Software & Services16%

Source: Venture Economics & National Venture Capital Association.

1.22 It is also helpful to examine the size and stage of the venture capital arrangements that are being funded. Not surprisingly, the biggest venture capital funds, those with committed assets in excess of $1 billion, represent the largest percentage of overall assets, yet the smallest percentage of funds. Interesting to note in Figure 7 is the fact that medium-sized funds ($100-$250 million) represent the greatest percentage of venture capital funds (337 funds), which might be surprising given the significant dollar flow in the market. As for the stage of underlying firm development attracting venture capitalists, the bulk of assets and funds seem to focus on a balanced approach in which managers attempt to diversify their holdings across the stage spectrum – a number of seed and early stage deals mixed with some later stage investments. Though the spread is not substantial, seed stage financing was the second most popular approach, again likely driven by the multitude of Internet deals in the marketplace.

Figure 7: Venture Capital Demand by Fund Size and Stage (1995-1999)

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Venture Capital: By Fund Size (Committed Capital)

0%

10%

20%

30%

40%

0 - 25

25 - 50

50 - 100

100 - 250

250 - 500

500 - 1,000

1,000+

Fund Size ($US Million)

% o

f Cap

ital

0%

5%

10%

15%

20%

25%

Perc

enta

ge o

f Fun

ds

% of Total Assets % of Total Funds

Venture Capital: By Fund Stage (Committed Capital)

0%

10%

20%

30%

40%

50%

Balanced Seed/ Early Expansion/ Later

Fund Stage

% o

f Cap

ital

0%

10%

20%

30%

40%

50%

Perc

enta

ge o

f Fun

ds

% of Total Assets % of Total Funds


Venture capital performance

1.23 Returns to venture capital have been exceptional, particularly over the period 1995 to 1999. One problem, however, persists in evaluating the performance of all private equity, particularly venture capital, and that is volatility. The lack of frequent market-to-market pricing creates dampened return volatility, which makes risk-adjusting returns a difficult process. Additionally, returns are typically presented in the form of internal rates of return (IRR) versus traditional time-weighted return calculations. Yet, return and diversification potential can be estimated. First, venture capital investments take place earlier in the business life cycle than any public investment. In the earlier stages of formation, a company's prospects are less dependent on the direction of the overall market and more a function of the value created within the firm itself. Thus, a venture capital portfolio could be expected to have a lower correlation with the broad market averages than a portfolio of large capitalization stocks. Secondly, venture capital companies can be purchased at significant discounts to their public market counterparts, a discount that arises from the non-liquid nature of the investment as well as from the fact that a transaction often involves acquiring a substantial portion of the underlying businesses. Also note that part of the private equity return pattern arises from the diminution of this private market discount as the investment moves out of the venture stage and is readied for a public offering. The table below highlights the performance of venture capital:

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Table 1: U.S. Venture Capital Performance (Pooled Average IRR)

Periods Ending September 30, 1999Annualized Returns

(%)

Calendar Year Returns

(%)

1 Year 61.82 1985 2.10

2 Years 33.08 1986 9.24

3 Years 33.08 1987 8.66

4 Years 35.89 1988 3.13

5 Years 34.61 1989 5.29

8 Years 27.02 1990 2.65

10 Years 23.26 1991 20.16

15 Years 16.72 1992 10.89

1993 19.57

1994 13.25

1995 44.26

1996 32.35

1997 28.93

1998 17.37

YTD 1999 47.78


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Buyouts and mezzanine financing

Definition

1.24 The term 'Buyouts' became synonymous with the leveraged acquisitions of the late 1980s, when large funds made combination debt/equity investments in order to gain management control of a company or to initiate the transfer of ownership. In a leveraged buyout, a premium may be paid for the element of control, as it is critical from the viewpoint of the purchaser to have the ability to restructure the target company’s operations. As the term implies, leveraged buyouts typically increase the financial leverage of companies through high levels of debt issuance. The increased use of debt generates greater financial risk, but also creates increased potential for return on equity. Buyout activity continues today, but without the high degree of leverage popular in its early days.

1.25 Buyout activity is based on the expected ability to increase a company’s profitability through structural initiatives that may often involve the sale of unrelated or undervalued subsidiaries or the consolidation of several related entities into one with enough critical mass to gain a competitive advantage. Given the greater financial leverage, companies with low operating leverage (and therefore low sensitivity to business cycle shifts) are often targets of buyouts.

Buyout and mezzanine financing growth

1.26 Unlike the impressive growth of its venture capital counterparts, the buyout deals witnessed a sizeable reduction in invested capital in 1999. Mezzanine financing, while increasing significantly in demand last year, still represents too little of the relative asset base ($4.3 billion) to counter the decline in buyout financing. Aside from the decline in committed capital, there was also a significant decrease in the number of funds available, dropping over 20% to 149 funds.

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Figure 8: Growth in U.S. Buyouts and Mezzanine Financing (1990 - 1999)


1.27 The decrease in assets is attributable to a variety of factors. First, as the demand and performance of venture capital has risen over the past, there is greater competition for institutional assets. Second, average buyout fund sizes are shrinking. According to the Private Equity Analyst, 1999’s average fund size of $348 million marked a one-third reduction from the 1998 average of $488 million. Yet, we must also note that the decline in average assets may have been expected, given the remarkable number of billion dollar funds that raised capital in 1998. 1999 saw only eight funds closing with assets in excess of $1 billion and none that reached the high-water mark of $3 billion mark crossed by four funds in 1998.

1.28 Completing the same analysis we conducted for venture capital demand, we can see that some of the same demand trends persist in the buyout arena. Private pension funds again represent the largest buyer of buyout and mezzanine investments, yet other investor types are more prominent. Notable demand is seen in many segments, with non-pension corporates, public funds, and individuals leading the way.

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Figure 9: Commitments to U.S. Buyouts & Mezzanine by Investor Type (1990-1999)

Buyout & Mezzanine Financing: Commitments by Investor Type1990-1994 versus 1995-1999

21.2%

15.0% 14.3%

22.6%

0.2%

9.7%12.5%

0.4%4.1%

9.5%

3.8%

16.9%13.4%

10.3%7.0%

4.0%7.3%

27.8%

0%

5%

10%

15%

20%

25%

30%


P rivateP ensions

P ubicP ensions

Family/Individuals



1990-1994 1995-1999

Buyout & Mezzanine Financing: Commitments by Investor Type1990-1999

10.1%

4.4%

16.8%

27.6%

12.7%10.3%

7.3%3.8%

7.1%

0%

5%

10%

15%

20%

25%

30%


P rivateP ensions

P ubicP ensions

Family/Individuals




1.29 It is also interesting to see the new sources of demand in buyout financing. Public pension funds increased relative allocations to the asset class by over 13% from the first to the last five years of the decade. Conversely, bank and insurance company allocations fell dramatically across the decade, each by over 10%.

1.30 The dramatic change in the composition of private equity investments in favour of venture capital is attributable to a number of factors. First, the boom in new technology ventures, as mentioned, has played an integral role. Second, the sheer amount of capital raised in 1997 and 1998 was seen by many as a 'bubble' raised in advance of opportunity and that 1999’s decline was simply a compensating move back to normal levels. Finally, the perceived availability of solid returns in buyout financing may have also suffered a bit over 1999 as the global capital markets rebounded sharply from the last half of 1998, bringing corporate valuations to new highs and effectively raising the price on prospective buyout candidates. The notion of higher effective prices leads to lower available returns, which when held out against the impressive performance in venture capital, may be enough to diminish investor appetite.

Buyout and mezzanine performance

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1.31 To demonstrate the relative performance of the asset class, one can look at the return figures provided in Table 2 below. Those that have maintained allocations to buyout and mezzanine funds have witnessed some very good absolute returns. Yet, simply comparing the performance numbers of buyout funds versus their venture capital counterparts offers some empirical support for the dramatic shift in assets towards venture capital. Indeed, buyout funds have recently produced returns that are unattractive against even traditional large cap equities and well below the 30%+ returns being generated in venture capital investments. It is also worth noting the reversal of fortune in buyout financing from the late 1980s, when buyout funds were significantly outperforming venture capital investments.

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Table 2: U.S. Buyout and Mezzanine Financing Performance (Pooled Average IRR)

Periods Ending September 30, 1999Annualized Returns

(%)


(%)

1 Year 15.23 1985 36.74

2 Years 15.23 1986 40.45

3 Years 16.95 1987 24.75

4 Years 17.22 1988 48.66

5 Years 16.87 1989 26.52

8 Years 18.17 1990 0.14

10 Years 16.78 1991 13.05

15 Years 21.33 1992 10.70

1993 32.42

1994 15.99

1995 11.98

1996 25.10

1997 18.45

1998 11.87

YTD 1999 11.65

Private placement debt

Private placement debt performance

1.32 Table 3 shows that performance in the private debt category has been fairly inconsistent over the past, as returns have ranged anywhere from slightly negative to impressive returns of over 20%. There appears to be some general correlation with the broader public bond markets, as noted in relative down years of 1994 and 1999, but private debt has outperformed the broader fixed income indices across most observed periods. Such relative outperformance is expected given the greater associated risks surrounding illiquidity and credit levels in private placement debt.

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Table 3: U.S. Private Placement Debt Performance

Periods Ending December 31, 1999U.S. Private Corporate Debt U.S. Private Mortgage Debt

Annualized Returns

(%)


(%)

Annualized Returns

(%)


(%)

1 Year 0.21 1985 --- 1 Year 0.73 1985 ---

2 Years 3.77 1986 --- 2 Years 4.43 1986 ---

3 Years 5.61 1987 --- 3 Years 6.63 1987 ---

4 Years 5.56 1988 --- 4 Years 6.19 1988 ---

5 Years 8.40 1989 13.41 5 Years 8.71 1989 16.51

8 Years 7.65 1990 9.03 8 Years 7.72 1990 11.91

10 Years 8.81 1991 18.24 10 Years 8.96 1991 16.28

15 Years --- 1992 8.96 15 Years --- 1992 9.61

1993 12.55 1993 10.84

1994 -1.72 1994 -1.70

1995 20.54 1995 19.36

1996 5.40 1996 4.89

1997 9.41 1997 11.17

1998 7.45 1998 8.27

1999 0.21 1999 0.73

Definition

1.33 The public market strategies that have garnered the most attention over the recent few years are hedge funds. To many investors, the term 'Hedge Fund' connotes images of the Long-Term Capital Management (LTCM) debacle of 1998 or high profile 'market gurus' such as George Soros or Julian Robertson. Yet, the term hedge fund actually refers to a number of different

3 Public market strategies

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types of funds representing a broad range of investment strategies. In general, hedge fund managers seek to provide returns that are uncorrelated with a benchmark or index. While their returns may be compared to a benchmark, the characteristics of that benchmark and how returns are generated are not typically related. In essence, hedge fund managers aim to provide the best absolute returns, regardless of market direction.

1.34 Hedge funds may operate within only the domestic equity market or may seek to invest globally. The key difference between a hedge fund and a typical U.S., international or global equity portfolio relates specifically to the much broader operating guidelines, in particular the ability to hold a net 'short' position in the market, and/or to use leverage. In a traditional equity portfolio, the emphasis is on diversification. Hedge funds, in contrast, are typified by a concentrated approach to the execution of the underlying strategies. The broad operating guidelines and concentrated approach, combined with the effect of leverage, tend to make hedge funds much riskier than typical equity portfolios.

1.35 Hedge funds have developed a reputation for producing stellar returns. However, during the early stages of 1994, a number of hedge funds that concentrated their investments in mortgage derivative products experienced heavy losses. And, in 1998, a number of funds with large concentrations in sovereign debt suffered a similar fate. As was learned through the demise of LTCM, the use of excessive leverage can magnify the effect of correct or incorrect active decisions.

1.36 Most hedge fund managers are boutiques with less than $100 million in assets and virtually all use special structures and offshore domiciles to avoid regulation. The predominant clients of hedge funds are high net-worth individuals who represent around fifty percent of the aggregate assets managed. Yet, a few hedge funds are quite large with over $1 billion in assets. In fact, it is estimated that 15% of hedge fund managers control 80% of total assets, making the structure of the industry quite top-heavy. Most hedge fund managers are typically very closed-mouthed about their business and investment strategies, although calls for transparency are mounting.

1.37 Hedge funds can be classified in terms of how they invest and within which markets they usually operate, as listed below:

Global macro – Global Macro managers have tended to attract a good deal of bad press. These managers often take large bets on economies and currencies and thus have become the bête noire of many a politician. Malaysia's Prime Minister, for example, has described them as 'the highwaymen of the global economy'.

Event-driven – Event-driven managers seek investment opportunities surrounding corporate events. This group includes the merger arbitrage managers who seek to profit from the spreads in the share price between the acquirer and the acquired in corporate mergers and the so-called 'vulture' funds, which strip the assets of distressed or bankrupt companies. Merger arbitrage attempts to take advantage of

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the uncertainty surrounding the announced acquisitions. The merger arbitrage investor hopes for a bidding war to follow the initial announcement, and hopes that the deal will not fall apart or take too long to complete (longer time periods dilute the rate of return for a given price). Although merger-arbitrage returns are generally entirely deal-specific, managers will occasionally purchase index put options to protect against a general market collapse (which could jeopardise a high-priced acquisition). Other risks, such as whether a regulatory agency or the Federal Trade Commission would negate a possible deal for competitive reasons, cannot be hedged away.

Trading strategies – These managers use trading models which may be trend following, or may seek relationships between the behavior of different markets and variables. These tend to be highly technical, proprietary approaches.

Long/short – A long-short manager seeks simply to buy securities that it expects to outperform the market and sell short securities that its research indicates will underperform the market. There is no attempt to ensure that the dollar amount long is offset by an equal dollar amount short, nor are securities selected which are expected to 'hedge' one another. Long-short strategies, therefore, place a distinct emphasis on the stock picking abilities of investment managers.

Market neutral – Market neutral strategies invest in one security while hedging the underlying risk of that investment with another security. Market neutral portfolios are generally comprised of three basic components; long positions, short positions; and a risk control program that is designed to ensure that the combined long and short portfolio is immune to the systematic risk of the underlying asset class. The goal is to take advantage of security mispricing without exposure to market risk. The objective of a market neutral strategy is to achieve stable absolute returns regardless of the market direction. The total return on a market neutral portfolio is the sum of the return on the long portfolio, plus the return on the short portfolio, plus the net interest earnings.

Equitized market neutral – Market neutral portfolios may be 'equitized' in which systematic risk can be added back to the portfolio through a long position in futures contracts. The return to an equitized long-short portfolio would be similar to the portfolio return of the market neutral strategy, with the additional return on an S&P 500 futures contract.

Short selling – Short sellers attempt to identify stocks which are fundamentally overvalued or are troubled (bad management, grossly misrepresented their financial status or prospects). The short seller will then borrow the shares from a broker and sell the borrowed shares. Proceeds from the sale, plus a margin amount, are held as collateral. The short seller must pay all dividends to the original owners of the borrowed shares. Short sellers do not attempt to profit only during declining markets. Instead, they tend to be fully invested, believing that overvalued stocks or those with poor prospects can be identified and sold.

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Relative value arbitrage – These managers seek returns from the changes in the expected relationship between one security or position and a related one. The now infamous Long-Term Capital Management was a manager of this type, seeking gains from the expected convergence of similar fixed income positions. Because these gains are usually small and are perceived to be 'risk free', the managers tend to use significant leverage to enhance returns. Convertible bond arbitrage is another relative value strategy.

Managed futures – The futures market grew out of the privately negotiated market for forward contracts. Futures markets, in fact, are simply standardised, actively traded, forward contracts. The most important distinction in an organised futures market is that the exchange also acts as the final guarantor of trades made. Futures contracts no longer represent just commodities such as energy, precious metals, and agricultural products, but also financial instruments such as foreign currencies, interest rate instruments, and stock index contracts. Managed futures programs attempt to profit from price changes (whether up or down) that occur in any of these contracts. Most trading strategies attempt to take advantage of markets where prices move in a general trend up or down for an extended period of time. These types of markets, in contrast to flat or choppy markets, tend to reward managed futures portfolios. A given trader (CTA, or Commodities Trading Advisor) will tend to specialise in a narrow range of contracts. A diversified futures portfolio is constructed by hiring multiple managers of contrasting styles across the various contracts.

Multi-strategy funds – Multi-strategy funds invest in a wide range of hedge fund strategies in order to provide investors with a diversified hedge fund program. Multi-strategy fund managers evaluate various investment managers and asset classes to determine their fund’s asset allocation by investment strategy and manager. By offering a diversified program of alternative investments, multi-strategy funds tend to have low correlations with the returns on traditional equity and fixed income investments. These funds will also tend to have higher management fees based upon the multi-strategy fund manager’s expertise in selecting and monitoring the funds used.

Hedge fund growth

1.38 Reliable estimates of the total size of the hedge fund universe are even more difficult to obtain than private market as the industry is characteristically silent. The secrecy that surrounds hedge fund investing is deep rooted within an industry that historically could rely only upon word of mouth for asset growth. Unregistered by the SEC, hedge fund managers were prohibited from advertising or publicly promoting their services and, thus, an aura of secrecy was created. As these same funds started to compete with one another in arbitrage and quick timing deals, secrecy became even more important for ensuring nimbleness and for protecting short positions in the markets. As the numbers of hedge funds have grown, however, the inherent secrecy and

21

lack of transparency has started to emerge as an issue preventing greater involvement by institutions in this area.

1.39 Figure 11 looks at the growth in the hedge fund industry since 1988. We note here that growth has been relatively consistent and substantial. Despite the well noted problems of LTCM and other high profile hedge funds, the industry in general continues to expand and even maintained its momentum in 1998 when hedge funds were coming under increasing criticism. In fact, asset growth through the mid-point of 1999 had picked up over 1998’s relatively slow 5% expansion and was back close to 15% for the year. What one does see, however, is that the growth in the number of hedge funds in the marketplace is slowing down. While still increasing, the growth rate in new funds has slowed to mid-single digits (6-9%) and shows some signs of slowing further.

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Figure 10: Growth in U.S. Hedge Funds (1988 - June 1999)

Source: VAN Hedge Fund Advisors International.

1.40 The emergence of very specialized areas of hedge fund management style contributed to the displayed growth in the asset class. As discussed, Global Macro hedge fund managers tend to receive much of the headlines, which may help explain why they represent such a significant percentage of overall assets, yet such a small percentage of overall funds. Yet, as the demand for hedge fund management has grown, fund managers have attempted to promote themselves as specialists in various niches of the market, leading to a very diverse segmentation of the hedge fund marketplace, as depicted in Figure 12. While shown here in fairly broad terms, each of these categories could be further subdivided into more specialized areas.

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Figure 11: Global Allocation of Hedge Funds by Strategy (As of December 1998)

Source: Tremont Partners, Inc. and TASS Investment Research. (* Fund of Funds: Assets are not provided to prevent double counting.)

1.41 A recent analysis of the types of investors currently invested in hedge funds indicates that high net-worth individuals still comprise the greatest market, both in the U.S. and abroad. Yet, aside from individuals, the make-up of the hedge fund marketplace is quite different inside and outside the U.S., as seen in the disparity of demand among banks, insurance companies, pensions and endowments. The disparity may change rather rapidly, however, as hedge funds managers increasingly extend their efforts to attract capital to international markets. We will examine the increased demand for alternative investments overseas as part of our discussion on future growth trends in Section IV.

Figure 12: Breakdown of Hedge Fund Investors (U.S. and Non-U.S.)

Source: Hedge Fund Research Inc. (HFR)

1.42 Much of the growth in hedge funds has come in the form of offshore investment vehicles due to the registration requirements imposed by the regulating authorities in the U.S. The prevailing tax laws in the U.S. and the tax implications for U.S. pension funds investing in hedge funds have also been important determinants of where hedge fund managers domicile their products.

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As shown in Figure 14, only 34% of hedge funds are actually domiciled in the U.S. and an even fewer number of managers are domiciled domestically.

Figure 13: Domicile of Hedge Funds and Hedge Fund Managers

Domicile of FundsDomicile of Fund Managers

Fund ManagersIn USA

9%

Fund Managers Outside USA

91%

Bahamas7% Bermuda

7%

British Virgin Islands17%

Cayman Islands19%

USA34%

Other16%

Source: Tremont Partners, Inc. and TASS Investment Research.

1.43 According to VAN Hedge Fund Advisors, hedge funds are quite diverse. Though characteristics have not yet been updated for 1999, information as of year-end 1998 displayed in Table 4 offers some insight into the average make-up of funds within the global hedge fund universe.

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Table 4: Characteristics of a Typical Hedge Fund (As of December 1998)

Fund Characteristics Mean Median Mode

Fund Size $93 million $25 million $10 million

Fund Age 5.5 years 4.7 years 4.0 years

Minimum Investment Required $590,000 $250,000 $250,000

Number of Entry Dates 38 12 12

Number of Exit Dates 31 4 4

Management Fee 1.30% 1.00% 1.00%

Performance Allocation ('Fee') 15.30% 20.00% 20.00%

Manager’s Experience:

In Securities Industry 17 years 15 years 10 years

In Portfolio Management 11 years 10 years 10 years

Yes

Manager is a U.S. registered investment advisor 50%

Fund has hurdle rate 16%

Fund has high water mark 72%

Fund has audited financial statements/audited performance 94%

Manager has $500,000 of own money in fund 48%

Fund is diversified 60%

Fund can short sell 79%

Fund can use leverage 71%

Fund uses derivatives for hedging only, or none 66%


1.44 The issue of leverage, which is often quoted as a potential obstacle for institutional investment, is also quite mixed based upon the various hedge fund styles. The typical use of leverage varies from nearly 60% of distressed securities funds that do not use to leverage to only 12% of macro hedge funds that do not. On average, nearly 72% of the global hedge fund universe employs leverage to some degree or another, though the majority of those that do will only use leverage in relatively modest increments, less than 2:1.

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Table 5: Global Hedge Funds’ Use of Leverage (As of December 1998)

Don’t Use Use Leverage

Hedge Fund Style Leverage Low (<2.0:1) High (>2.0:1) Total

Aggressive Growth 33.6% 59.6% 6.8% 66.4%

Distressed Securities 58.9% 37.5% 3.6% 41.1%

Fund of Funds 22.3% 57.4% 20.3% 77.7%

Income 36.8% 44.7% 18.4% 63.2%

Global Macro 12.3% 53.8% 33.8% 87.7%

Market Neutral - Arbitrage 18.1% 25.1% 56.7% 81.9%

Market Neutral - Securities Hedging 29.1% 47.2% 23.6% 70.9%

Market Timing 29.5% 39.7% 30.8% 70.5%

Multi- Strategies 37.9% 50.0% 12.1% 62.1%

Short Selling 20.5% 74.4% 5.1% 79.5%

Special Situations 18.2% 76.4% 5.4% 81.8%

Value 34.4% 62.6% 3.0% 65.6%

Total Sample 28.2% 55.8% 16.0% 71.8%


1.45 Close on the heels of allowable leverage as an investor concern is the issue of transparency, or lack thereof. Yet, as pointed out in a recent publication by Tremont Advisors, transparency can be a double-edged sword. While investors often seek transparency as a requirement for ensuring that plan guidelines and restrictions are being adhered to, greater transparency can also lead to diminished excess returns. As greater transparency is introduced, there is a higher likelihood that information will be available to hedge fund competitors, thereby eliminating some of the information advantage that is often critical for generating alpha. Despite this inherent need for hedge fund managers to maintain the most extreme levels of secrecy, numerous managers have expressed a greater willingness to open up their portfolios to investors. This trend has been slow to take hold and is still typically applied only after investment, but the sheer number of managers entering the marketplace in recent years has created additional pressure for managers to make themselves more open as a means of ensuring investor confidence.

1.46 Transparency is also being addressed from a variety of new sources. Many institutional investors have gone the route of allocating responsibility for ensuring guideline compliance to fund-of-fund managers. Fund-of-fund managers typically have established relationships with hedge fund managers that allow them greater access to investment-level information. While fund-of-fund managers may subsequently be restricted in their ability to share such information, the institutional investor can effectively delegate the oversight to the manager. In addition to providing greater access to the top performing hedge fund managers, the ability to look within

27

the underlying portfolios has been one of the fund-of-fund manager’s most noted advantages and has helped drive significant growth in this area. Another interesting development along these lines is the introduction of some Internet-based firms that are offering both increased liquidity and better transparency to accredited investors. As will be discussed in more detail under our discussion on future growth trends, websites such as HedgeWorld.com and PlusFunds.net are aiming to bring secondary market liquidity and increased transparency to the hedge fund marketplace.

1.47 One of the most attractive aspects of hedge funds lies in their purported ability to deliver higher risk-adjusted returns than traditional investment classes. Yet, here again, one must carefully evaluate the performance numbers in the context of true risks. Aside from just standard deviation of returns, hedge funds inherently carry greater external risks through investments in lower liquidity securities and in their tendency to incorporate leverage into their strategy. Such risks may not be effectively captured simply in return deviations. Coupled with other factors such as reduced transparency and 'lock-up' periods, accurate risk-return tradeoffs are often difficult to determine.

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Figure 14: Risk-Return Tradeoffs in Hedge Funds (1993 - June 1999)

Source: Hedge Fund Research Inc. (HFR)

1.48 Given these observed risk-adjusted benefits, hedge funds have become an increasingly popular way for U.S. plan sponsors to diversify their institutional portfolios. While allocations are still only marginal, there is an increasing trend towards considering hedge fund investments as part of a plan’s alternative investment program. According to a recent survey by Goldman Sachs and Frank Russell, plan sponsors reported a sizeable increase in their investments in hedge fund portfolios, specifically that those responding had increased invested assets from $1.7 billion to $5.6 billion in 1999 alone. Notably, the greatest respondents for hedge fund activity were endowments and foundations (77%), which follows along the widely held belief that endowments and foundations are more likely to invest in hedge funds because of their less stringent liability matching needs. Among those surveyed who indicated that they did not have an allocation to hedge funds, the top reasons provided were: (1) concerns about the risk/return profile, (2) hedge funds investments were prohibited legally or by investment policy guidelines and, (3) concerns over lack of disclosure or transparency.

1.49 Again, one must be careful in interpreting these results. Hedge fund categories as we have defined them are not universal. In fact, many of the survey respondents indicated that they considered market neutral strategies as part of their traditional equity strategies. Thus, some estimates of hedge fund allocations may be understated or not simply defined in similar ways. In addition, the limited sample size of those responding about hedge fund investments may also create inherent reporting biases (i.e. some sponsors may not report hedge fund allocations

29

because of privacy concerns or misunderstandings about how the asset class is being defined). Regardless, the information gathered does highlight the growing acceptance among institutional investors for hedge fund alternatives.

Hedge fund performance

1.50 Returns to hedge fund investors have been mixed over the recent past, depending upon the type of fund style examined. As depicted in Tables 6 and 7, all hedge fund styles, except short selling strategies, have posted relatively strong long-term returns in excess of 10%.

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Table 6: Global Hedge Fund Annualised Net Performance by Style

Periods Ending December 31, 1999

Aggressive Distressed Fund of Global Market Neutral Market Multi- Short Special VAN Hedge

Growth Securities Funds Income Macro Arbitrage Hedging Timing Strategy Selling Situations Value Fund Index

1 Year 80.40 3.30 33.70 7.00 46.20 20.00 26.40 39.80 39.40 -19.40 36.30 42.00 39.50

2 Years 54.37 1.53 17.35 3.60 24.37 12.41 17.00 38.09 22.81 -17.13 21.94 26.28 21.60

3 Years 39.66 5.22 16.53 4.85 22.86 14.53 17.43 31.11 20.22 -9.57 22.29 25.14 19.57

4 Years 34.12 8.46 16.37 5.58 20.74 15.37 19.06 26.77 19.28 -9.43 22.60 24.04 19.32

5 Years 33.74 10.12 16.26 6.27 18.36 15.19 18.42 23.20 19.72 -10.51 22.40 24.47 19.06

6 Years 27.43 8.99 12.74 5.10 12.27 12.97 15.94 18.61 16.20 -6.81 18.96 20.51 15.72

7 Years 26.91 11.88 14.32 7.28 16.73 13.76 16.80 18.87 17.33 -6.81 20.35 21.59 17.53

8 Years 25.57 13.52 13.94 8.20 16.77 13.89 16.62 18.00 17.47 -5.10 19.98 20.80 17.47

9 Years 27.70 15.96 13.78 9.97 19.22 14.31 17.25 20.79 18.98 -6.85 20.93 21.84 18.74

10 Years 24.94 14.99 13.64 10.16 17.95 13.77 17.48 20.27 17.42 -3.09 19.95 19.54 17.52

11 Years 25.55 15.89 14.26 10.21 19.56 13.80 17.51 20.76 17.99 -0.92 19.72 19.78 18.17

12 Years 24.88 20.39 14.48 10.28 20.77 15.20 17.62 21.02 18.56 0.36 21.35 20.02 18.73

13 Years --- --- --- --- --- --- --- --- --- --- --- --- ---

14 Years --- --- --- --- --- --- --- --- --- --- --- --- ---

15 Years --- --- --- --- --- --- --- --- --- --- --- --- ---

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Table 7: Global Hedge Fund Calendar Year Net Performance by StyleAggressive Distresse

d

Fund of Global Market Neutral Market Multi- Short Special VAN Hedge

Growth Securities Funds Income Macro Arbitrage Hedging Timing Strategy Selling Situations Value Fund Index

1985 --- --- --- --- --- --- --- --- --- --- --- --- ---

1986 --- --- --- --- --- --- --- --- --- --- --- --- ---

1987 --- --- --- --- --- --- --- --- --- --- --- --- ---

1988 17.80 83.00 17.00 11.00 34.90 31.80 18.90 23.90 25.00 15.50 40.70 22.70 25.00

1989 31.80 25.30 20.60 10.80 36.90 14.00 17.80 25.80 23.90 23.70 17.50 22.20 24.90

1990 2.60 6.60 12.40 11.80 7.10 9.10 19.50 15.70 4.20 38.40 11.50 0.70 7.10

1991 46.10 37.50 12.50 25.30 40.80 17.70 22.50 45.60 31.80 -19.80 28.80 30.50 29.40

1992 16.60 25.70 11.30 14.80 17.00 14.80 15.30 12.10 18.50 7.80 17.40 15.40 17.00

1993 23.80 30.90 24.30 21.40 47.50 18.60 22.10 20.40 24.30 -6.80 29.00 28.30 29.00

1994 0.10 3.50 -3.30 -0.60 -13.80 2.50 4.30 -1.90 0.10 14.10 3.20 2.50 0.40

1995 32.20 17.00 15.80 9.10 9.30 14.50 15.90 9.90 21.50 -14.70 21.60 26.20 18.00

1996 18.80 18.80 15.90 7.80 14.60 17.90 24.10 14.60 16.50 -9.00 23.50 20.80 18.60

1997 14.30 13.00 14.90 7.40 19.90 18.90 18.30 18.20 15.20 7.70 23.00 22.90 15.60

1998 32.10 -0.20 3.00 0.30 5.80 5.30 8.30 36.40 8.20 -14.80 9.10 12.30 6.00

1999 80.40 3.30 33.70 7.00 46.20 20.00 26.40 39.80 39.40 -19.40 36.30 42.00 39.50


1.51 Thus far, we have looked primarily at the current demand for alternative investments in the U.S. and how investor demand has evolved over the past number of years. The logical next question then turns to what can be reasonably expected in terms of growth going forward and what factors will most heavily influence these future trends.

4 Future growth trends

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1.52 As an entire asset class, the recent trend towards higher allocations to alternative investments is likely to continue. Supported by survey data from Goldman Sachs and Frank Russell, the average plan sponsor anticipates that their strategic allocation to alternatives will rise to 8% over the next three years. Data available from Greenwich Associates makes similar projections, with noted growth in many of the asset class segments explored in this paper. Not surprisingly, the breakdown of projected demand in the Greenwich survey indicates that the largest growth segment among each of the plan sponsor categories is among those plans with over $1 billion in assets.

Table 8: Projected Institutional Demand for Alternative Assets

Demand for

Venture Capital

Now

Use

Have Hired

New Mgr.

Expect

to Hire

Demand for

Hedge Funds

Now

Use

Would

Consider

Total

Demand

Corporate Funds 14% 4% 3% Corporate Funds 4% 7% 11%

Public Funds 15% 6% 6% Public Funds 2% 5% 8%

Endowments 39% 21% 18% Endowments 32% 39% 71%

Total Funds 19% 7% 7% Total Funds 9% 13% 22%

Buyout Funds

Corporate Funds 9% 4% 3%

Public Funds 8% 5% 4%

Endowments 28% 16% 12%

Total Funds 12% 6% 5%

Mezzanine Funds

Corporate Funds 6% 2% 2%

Public Funds 7% 2% 3%

Endowments 16% 4% 4%

Total Funds 8% 3% 2%

Source: Greenwich Associates.

1.53 For private equity, indications seem to point to continued expansion in the asset class, driven most predominantly by a rapidly expanding venture capital market. Aside from asset appreciation, private equity investments will likely see greater allocations from institutional investors going forward. The expanded allocations represent two distinct trends among private equity investments: (1) an increasing acceptance of private equity as an asset class with attractive return potential and, (2) increasing attention by plan sponsors as to the level of their invested assets and less for their committed assets. On the second point, plan sponsors are finding it increasingly difficult to put their full private equity allocations to work in the market, as funds are becoming increasingly selective in who can invest and are turning over those assets already invested at increasing rates. While a plan sponsor may allocate and commit 10% of

33

their assets to private equity, draw-down practices within the industry typically mean that the plan may only have 6% of their committed assets actually invested at any one point in time. Thus, to reach an invested level of 10%, these plan sponsors have to increase their overall allocations to 15%. Coupled with the first point on increased acceptance and attractive return potential, private equity allocations will likely increase significantly.

1.54 More specific to venture capital investments, the trends seem to be generally positive with respect to anticipated future asset growth. As technology ventures continue to be the stuff of legends in the IPO markets, venture capital commitments will likely continue to chase them. The fact that investors are also receiving big dividends on their current investments means that they can continue to invest in the asset class without having to dig too deep within their pockets. What may be surprising, however, is the fact that venture capital managers may begin to shun the institutional marketplace in favor of wealthy individuals. The incredible wealth generation afforded over the past five years by investments in the Internet and Internet start-ups has created a now significant segment of the market that has tremendous levels of high net-worth capital available for investment. In addition to just absolute levels of available capital, the private investor can offer something which institutional investors typically cannot and that is the expertise and networking contacts necessary to make the underlying firms grow and prosper.

1.55 Evidence of this trend is already being seen among some of the U.S.’s largest venture capital firms. In the recent past, J.P. Morgan and their client AT&T were eliminated from participation in the fund raising efforts for one of the three largest venture capital partnerships, which instead sought capital from purely 'friends of the firm'. In recognition of the fact that institutions have long been an attractive target market, some other venture capital firms are hoping to create the best of both worlds. By implementing 'friend funds' alongside their institutional partnerships, venture capitalists are able to gather the sizable institutional assets while also benefiting from the individual’s expertise. The institutions benefit from continued access to deal-flow, while individuals benefit from off-loading the management fees to the institutions. In any event, institutional investors are feeling the pressures to demonstrate that they have more to offer than simply money. The alternative for many institutions is to provide backing to smaller or newly formed venture capital firms. This is providing an obvious benefit to the new and emerging venture capitalists and may help drive the continue expansion in both industry assets and the number of funds entering the market. Ironically, venture capital, riding the wave of a prospering economy, has proceeded to the point where money is now considered a commodity - seemingly everyone has extra to spend. Thus the venture capital markets may well continue along their path of rapid expansion, but it will be interesting to see how and if the composition of investors changes along the way.

1.56 Any difficulty in increasing invested allocations to venture capital may be the buyout funds’ gain. Still representing the largest segment of the private equity market among tax-exempt plan sponsors, buyouts may be able to reverse the recent trend of capital flowing out of the asset class. While not expected to produce the same level of returns as venture capital over the near-term, the anticipated 20% returns to buyout funds expressed by Goldman/Russell respondents is

34

still attractive. Should venture capital investments post disappointing returns, shifts back into later stage and typically more stable buyout investments may be rapid. The question for assessing future growth in the asset class may then be more focused around what types of opportunities are made available and less around whether there is investor appetite. Should the trend away from mega-buyout funds witnessed in 1999 continue, the competition among institutional investors for fund accessibility will likely increase, much as is seen currently in venture capital. The increased bidding may result in greater allocations by plan sponsors, as noted in the Greenwich table above. Certainly, buyout fund providers will attempt to capitalize on this increased appetite, but one must still question whether this will actually result in increased investment. Despite increasing investor commitments, actual investment may diminish if there is a perceived lack of underlying investment opportunity for the buyout fund manager. The good news, however, is that recent trend towards global integration and new investment opportunities abroad may present enough deal-flow to handle demand.

1.57 For the hedge fund investor, the prospects also look quite promising. KPMG recently predicted that the amount invested in hedge funds would jump to $3,000 billion by the year 2005, maintaining the 25%+ growth witnessed in some recent years. Driving this growth will be investments from overseas investors and a general move by hedge funds into mainstream investment portfolios. Indeed, numerous people are predicting a move to make hedge funds available to traditional retail investors on a much broader scale, which would almost certainly push asset growth to new levels. Yet, such growth predictions might not be attainable were it not for the coincident movements to increase both liquidity and transparency. As mentioned, basic supply and demand forces are forcing transparency upon hedge fund managers. There are too many skilled managers leaving traditional investment management positions for hedge funds to make the historical secrecy of hedge fund investments last. While some level of limited disclosure will always be necessary to protect manager positions, the catering to the increasing institutional presence and the need to fit hedge funds within traditional institutional frameworks will drive greater information sharing. Competitive pressures will also have a dramatic impact on the level of fees currently being garnered by hedge fund managers. Already, some institutional investors are seeing fee reductions, particularly in the performance fees typically laid on top of standard management fees.

1.58 Transparency is also being provided in new ways, such as the PlusFunds.net website that is now offering 'benign' transparency to its members, whereby investors can see real-time changes in the value of their portfolio without access to specific holdings. At the same time, the mystery surrounding hedge funds is diminishing as situations such as with Long-Term Capital have prompted investors to learn more about the asset class. This education process has helped to break down many of the myths surrounding hedge funds and to eliminate the notion that all hedge funds are created equal. Investors are learning about the impact of leverage and the different levels of risk inherent to each of the different fund styles.

1.59 Other notable efforts are being made by the hedge fund industry to make their products more appealing to mainstream investors. Business operations, including marketing and client

35

servicing, at hedge fund shops are expanding in an attempt to offer potential investors more established lines of contact with their organization. Distribution is also becoming an area of increased focus. Hedge funds are looking to partner with established investment firms as a new channel for distribution to traditional markets. Additionally, websites such as HedgeWorld.com are offering secondary market liquidity for hedge fund investors who can use the site to swap shares and thus escape some of the difficulties associated with lock-up windows and limited selling opportunities. Success in these endeavors will drive more acceptance of the asset class in general, which coupled with continued strong performance may make hedge fund investments as common tomorrow as mutual funds are today.

1.60 One final growth trend worth noting is the increasing movement among alternative investors to opportunities outside the U.S. According to numerous reports by industry practitioners, institutional investors are flocking to foreign markets, prompted by the increased competition for access to top managers in the U.S. and a prevailing sense that the stellar recent domestic returns can be replicated in the international markets. As noted in the Private Equity Analyst and Pensions & Investments, the favorite destination for those investing in private equity overseas is Europe, typically under a Pan-European approach. Cognizant of the inherent risks associated with investments in other countries, investors are paying particular attention to differences in valuation guidelines, liquidity, pricing services and historical data as key distinguishing factors in deciding which partnerships to back. To combat these concerns, many U.S. investors are making increasing use of fund-of-fund arrangements, despite higher fees, as a means of diversifying their risks.

1.61 Within venture capital, there are additional risks that are made more difficult by the move abroad. The inflow of capital into the venture capital funds is causing some concerns among current investors. Given the relatively small size of some of the attractive European markets, there may simply not be enough underlying companies worth investing in at this point. Put plainly, many feel there is only so much venture capital money that Europe can handle and thus any new assets may see diminishing returns on investment. The problem is likely to continue however, as investors see the tremendous potential for Internet companies abroad to replicate the business success witnessed in the U.S. Investors would prefer to be early and thus can be expected to stay invested overseas for at least the near future. Evidence of this can be seen in the fact that U.S. venture capital firms placed almost $294 million in European Internet deals, as compared to only $37 million provided by European venture firms. According to the Venture Capital Journal, venture investors generally believe that there is approximately a two-year lag in Internet technology development overseas, which if true may lead to a flood of new assets in international venture capital as was witnessed in the U.S. in the late 1990s.

1.62 Thus, we have seen that the demand for alternative assets among institutional investors is growing, driven by the need for investors to diversify plan assets that have grown considerably in the markets’ prolonged expansion. Early-stage private equity investments are riding the near legendary efforts among Internet entrepreneurs to be the next Amazon.com, while later stage and buyout funds are capitalizing on continued pressures for domestic firms to expand through

36

global acquisition. Hedge funds have grown up dramatically from once mysterious folklore to now hoping to establish themselves as the next great addition to any well-diversified retail or institutional portfolio. With the growth of the markets has come increased competition among even the largest investors for access to quality fund management in any of the alternative areas. The entire industry is trying to show that they can bring something additional to the table, many managers need more than just investor assets and investors want more of the features of investing that they have become accustomed to in the traditional markets. Time will tell how the markets choose to grow, but all signals indicate that whatever the direction, the growth will be significant.

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2

a.a. One Year

Three Years

Five Years

Eight Years

Ten Years

Fifteen Years

Private Market Strategies For Periods Ending September 1999

All U.S. Private Equity Funds 28.73% 22.09% 22.64% 21.06% 18.80% 17.00%U.S. Venture Capital Funds 61.82% 33.08% 34.61% 27.02% 23.26% 16.72%U.S. Buyout & Mezzanine Funds 15.23% 16.95% 16.87% 18.17% 16.78% 21.33%JP Morgan Private Corporate Debt Fund

0.00% 6.81% 8.50% 8.46% 9.20% ---

JP Morgan Private Mortgage Debt Fund

0.73% 7.69% 8.73% 8.32% 9.32% ---

S&P 500 Index 27.76% 25.10% 25.03% 18.82% 16.81% 17.97%MSCI EAFE Index 30.95% 10.43% 9.12% 9.01% 5.82% 15.12%Lehman Brothers Aggregate Bond Index

-0.37% 6.82% 7.84% 7.22% 8.10% 9.76%

90 U.S. T-Bills 4.53% 4.87% 5.03% 4.46% 4.93% 5.59%

Public Market Strategies For Periods Ending December 1999Aggressive Growth 80.40% 39.66% 33.74% 25.57% 24.94% ---Distressed Securities 3.30% 5.22% 10.12% 13.52% 14.99% ---Fund of Funds 33.70% 16.53% 16.26% 13.94% 13.64% ---Global Macro 46.20% 22.86% 18.36% 16.77% 17.95% ---Income 7.00% 4.85% 6.27% 8.20% 10.16% ---Managed Futures -1.20% 7.05% 8.76% 6.51% 7.69% 11.78%Market Neutral - Arbitrage 20.00% 14.53% 15.19% 13.89% 13.77% ---Market Neutral - Securities Hedging 26.40% 17.43% 18.42% 16.62% 17.48% ---Market Timing 39.80% 31.11% 23.20% 18.00% 20.27% ---Multi-Strategies 39.40% 20.22% 19.72% 17.47% 17.42% ---Short Selling -

19.40%-9.57% -

10.51%-5.10% -3.09% ---

Special Situations 36.30% 22.29% 22.40% 19.98% 19.95% ---Value 42.00% 25.14% 24.47% 20.80% 19.54% ---VAN Global Hedge Fund Index 39.50% 19.57% 19.06% 17.47% 17.52% ---

S&P 500 Index 20.98% 27.55% 28.56% 19.69% 18.21% 18.93%

5 Performance summary

38

MSCI EAFE Index 26.96% 15.74% 12.83% 10.94% 7.01% 15.95%Lehman Brothers Aggregate Bond Index

-0.82% 5.73% 7.73% 6.55% 7.70% 9.21%

90 U.S. T-Bills 4.77% 4.89% 5.03% 4.49% 4.87% 5.53%

Sources: Venture Economics, J.P. Morgan, VAN Hedge Fund Advisors Intl. and Barclay Trading Group (Futures Index).

This paper relied heavily on data and information gathered by external sources:

Barry, David G. 'Institutions Getting Squeezed For Space In Venture Funds.' The Private Equity Analyst, June 1999.

Brown, Heidi. 'Surfing For Hedges.' Forbes.com, December 1999.

Chaffin, Joshua. 'Companies & Finance: The Americas.' Financial Times, December 1999.

Characteristics of A Typical Hedge Fund. VAN Hedge Fund Advisors International, VANHedge.com, 1999.

Davis, Jonathan. 'Tomorrow’s Hedge Funds Are Flourishing.' The Independent (London), December 1999.

Fulman, Rick. 'Venture Cap Did Well But Debt Did Better.' Pensions & Investments, January 2000.

Fulman, Ricki. 'Hard To Find Deals.' Pensions & Investments, November 1999.

Global Number of Funds by Strategy. VAN Hedge Fund Advisors International, VANHedge.com, 1999.

Goodman, Laurie S. 'Hedge Funds Going Forward.' The Journal of Alternative Investments, Spring 1999.

Hedge Funds Position For Increasing Competition. Institutional Investor, Inc., December 1999.

How Funds Are Coping with 'Uncertain Markets': A Report to Fund Professionals. Greenwich Associates, February 1999.

Johnson, Pitch. 'Venture Capital Spans the Globe.' Red Herring, April 1995.

Kelly, Bruce. 'Going Global: Funds Cautiously Bullish On Foreign Private Equity.' Pensions & Investments, May 1999.

Kelly, Bruce. 'Hot Category: Investors Find Ways Into Foreign Private Equity.' Pensions & Investments, May 1999.

A References

39

Lau, Deborah. 'European Internet Deals Soar.' Venture Capital Journal, December 1999.

Making The Case For Alternative Assets. Watson Wyatt Investment Consulting, August 1999.

Number of Hedge Funds Increases For Tenth Consecutive Year. VAN Hedge Fund Advisors International, VANHedge.com, September 1999.

Report on Alternative Investing by Tax-Exempt Organizations: 1999. Goldman Sachs & Co. and Frank Russell Company, November 1999.

Rule 144A Issuance in the High Yield Market. The Bond Market Association Research Quarterly, November 1999.

Scholl, Jaye. 'Opening the Kimono.' Barron’s, February 2000.

Special Report: Largest Funds. Pensions & Investments, January 2000.

Taylor, John. 'Venture Capital Investments for 1999 Reach Record.' Venture Economic News, SecuritiesData.com, February 2000.

The Venture Capital Industry: An Overview. NVCA.org, February 2000.

Tremont Partners, Inc. and TASS Investment Research. 'The Case For Hedge Funds.' The Journal of Alternative Investments, Winter 1999.

Use Of Leverage. VAN Hedge Fund Advisors International, VANHedge.com, 1999.

____. 'Funding Hits Record $96 Billion.' The Private Equity Analyst, January 2000.

____. 'International Funds Continuing To Grow.' The Private Equity Analyst, July 1998.

____. 'Mezzanine Fund Raising Slows Down.' The Private Equity Analyst, July 1998.

Performance and Universe Statistics Provided By:

Barclays Trading Group, BarclayGrp.com.

J.P. Morgan Investment Management.

VAN Hedge Fund Advisors International, VANHedge.com.

Venture Economics, Venture Expert Online Database, VentureEconomics.com.

40

B

Figures1 Demand for US private equity investment (1995-1999)2 Demand for USD private equity by investor type (1990-1999)3 Increasing allocations to private equity4 Growth in US venture capital (1990-1999)5 Commitments to US venture capital by investor type (1990-1999)6 Venture capital financing by industry sector7 Venture capital demand by fund size and stage (1995-1999)8 Growth in US buyouts and mezzanine financing (1990-1999)9 Commitments to US buyouts and mezzanine by investor type (1990-1999)10 Growth in US hedge funds (1988-June 1999)11 Global allocation of hedge funds by strategy (as of December 1998)12 Breakdown of hedge fund investors13 Domicile of hedge funds and hedge fund managers14 Risk-return tradeoffs in hedge funds (1993-June 1999)

Tables1 US venture capital performance (pooled average IRR)2 US buyout and mezzanine financing performance (pooled average IRR)3 US private placement debt performance4 Characteristics of a typical hedge fund (as of December 1998)5 Global hedge funds' use of leverage (as of December 1998)6 Global hedge fund annualised net performance by style7 Global hedge fund calendar year net performance by style8 Projected institutional demand for alternative assets

A Figures and tables

41

For further information contact:

Philip RobinsonSenior Investment ConsultantWatson Wyatt Partners+44 (0)1737 [email protected]

Charles BathurstHead of International MarketingAlternative Investment Products GroupIndocam Asset Management+44 (0)207 303 [email protected]

Bruce WraightPublic Relations ManagerWatson Wyatt Partners+44 (0)1737 [email protected]

Watson Wyatt Worldwide

A global consulting firm, Watson Wyatt brings together two disciplines – people and financial management – to help clients improve business performance.

Watson Wyatt has over 5,500 associates in 31 countries. They are backed by the best and most current research on people and financial management issues. Headquarters are in Reigate, England and Bethesda, Md, USA.

Watson Wyatt Investment Consulting is a specialist practice within WWW that operates in 23 countries and employs over 100 investment consultants. It services a client base of over 500 funds with assets worth in excess of $400 billion. Many clients are included in the Times 1000 and the Fortune 1000 lists.

Indocam Asset Management

Indocam Asset Management is the asset management company of the Crédit Agricole Group, with over euro 145 billion under management. Its global headquarters are in Paris, with additional investment offices in London, Tokyo, Hong Kong and Singapore, and marketing offices throughout Europe.

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Indocam has been actively managing alternative investment portfolios for institutional investors since 1992 through its Alternative Investment Group, located in Paris, London and Chicago. This group targets specific risk/return profiles that offer genuine portfolio diversification through low correlation to traditional assets.

Indocam has recognised the growing requirement of institutional investors to allocate to this asset class and as such has committed significant resources to meet this demand.

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